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Making do with limited 401(k) choices [ClearOnMoney]
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Making do with limited 401(k) choices

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Investment

Making do with limited 401(k) choices

21 Dec 2009 by Jim Fickett.

If I were restricted to a typical range of 401(k) mutual fund choices, I would be mostly in cash, with some conservative, global company stocks.

Someone showed me a list of their 401(k) mutual fund choices and asked what I would do. Obviously the appropriate choices depend on the individual; there is not one answer for everyone. Yet perhaps some of the considerations are of general interest, so I decided to answer the question here.

General -- a time for caution

First, a professional should put career first. Learn enough about investing to do a reasonable job, but spend your best time and energy on your career. This will pay off in the long run.

Second, get rid of the gambling mentality. Since the bottom in March there has been a recurring refrain of people saying they have to take big risks in order to make up for lost ground. Probably many of these were the same people who had to be 100% in equities just before the crash, because presumed high return from the stock market was the only way to make up for their lack of saving. Instead, contribute the legal maximum to your 401(k) and invest in a way that evidence and reason suggest will provide a positive return. You will sleep better and will probably end up ahead of the gamblers in the long run.

Third, we get to investing. This year a very diverse set of investments has gone up more than most people expected. The S&P 500 is up 63% from the bottom. Gold is up 26% since January. B-rated bonds have returned 48% in 2009, and C-rated bonds over 100%. Industrial metals are up 74% for the year. Whenever an investment goes up a lot, there are many people who explain why the trend will continue. Maybe so. I do not doubt that many of these investments could do well in 2010. The problem is that to invest now is a big gamble. There are very good arguments to suggest that all of the above investments are currently overvalued. Could they go up more? Absolutely. Could they go down significantly? Absolutely. It is important to make up your own mind about whether up or down is more likely, but even more important to recognize that both are quite possible.

The range of investments in the previous paragraph is illustrative of the mood, but only two investments are to be found in the average 401(k): stocks and bonds.

Bonds -- an accident waiting to happen

Bonds investors are showing excessive optimism. Here is long-term history of one investment grade bond yield index.

(Graph courtesy of the St. Louis Fed). Note that yields are almost back down to pre-crisis levels, which were at a very optimistic 40-year low. In other words, at a time when serious discussion of a possible double-dip recession is still fairly widespread, bonds are priced for a world almost without risk. Add to this that if (1) the record sales of US Treasuries begin to be received less enthusiastically, or (2) investors begin to worry more about inflation, long term bonds will suffer greatly.

In my view the bond market is an accident waiting to happen and I would not add any money there at present.

Stocks -- overvalued but don't stay out too long

Stocks globally are overvalued, in some countries more than others. The ratio of the price of the S&P 500, inflation adjusted, to earnings, again inflation-adjusted and averaged over the last 10 years to reduce distortions of the business cycle, is about 40% above its long-term trend (see this Gluskin Sheff newsletter for a chart – free registration required). 40% too high is not as bad as it could be; it was over twice its trend in 2000. But it still means that buying now means paying something like 40% above fair value.

I am mostly in cash. I sold all broad equity funds in the summer of 2007 and took a position consisting of a few defensive stocks and an S&P inverse ETF that gave me a small net short position. After the crash sparked by the failure of Lehman, I began to go net long, but stayed mostly in cash. So, even though I was pretty sure in 2007 that the market was going to fall, I had only a small short position on the way down, and even though I was pretty sure the market was cheap after October 2008, I took only a small net long position. At volatile times like the present it is reasonable to be rather careful. I didn't make a lot of money in the last two and a half years, but I did make money through the whole crisis.

At present, the economic and business fundamentals are not very positive. This is offset by a large amount of cheap lending from the government that encourages speculation. These are strong opposing forces for stocks. I personally think the cheap money will win for a bit longer and then sometime next year we will see a significant correction. However this could very well be wrong (several months ago I also thought that the rally was nearing its top).

On the one hand, then, one wants to have a significant position in equities long term (the younger one is, the more so). On the other hand, equities are probably expensive just now. Resolving this tension is really the most difficult question (for stock investment) at present. Here is how I resolve it: I think that if there is indeed a pullback in the market, it is likely to happen in the next year or so, so as a medium-term goal I want to have a significantly heavier position in equities about a year from now, and I intend to start slowly now. Since stocks in general are expensive now, I am most interested in buying particular stocks that have gone up less than average this year, for example large, global, non-financial companies with little debt.

With that background, back to the 401(k) question. If I were young (as was my questioner) and in a typical 401(k) scenario, I would implement these ideas by looking for a large cap value fund with the kinds of companies just mentioned, and putting 10-20% there. (Emerging market equities could also be attractive, but I think they need country-level selection, which is unlikely to be available.) In the long run this will provide reasonable returns no matter what happens next year. The rest I would keep in cash, looking to add significantly more stocks next year, hopefully after a correction.