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Popular 401K investors delusions

So, Mr. Ricky Stock Mutual Fund says, "Give me $10 in order for me to lose you $8, and I'll give you $2 dollars back for your inconvenience."

Is in this case a 401K investor in a the wrong business or what?

It was a very good editorial published in WSJ on Aug 24, 2009 about biases that 401K investors have (Investment Mistakes The View From Behavioral Finance)

If there's one question that investors have asked themselves over the past year and a half, it's that one. If only I had acted differently...

Yet here's the problem: While we know that we made investment mistakes, and vow not to repeat them, most people have only the vaguest sense of what those mistakes were, or, more important, why they made them. Why did we think and feel and behave as we did? Why did we act in a way that today, in hindsight, seems so obviously stupid? Only by understanding the answer to these questions can we begin to improve our financial future.

This is where behavioral finance comes in. Most investors are intelligent people, neither irrational nor insane. But behavioral finance tells us we are also normal, with brains that are often full and emotions that are often overflowing. And that means we are normal smart at times, and normal stupid at others.

The trick, therefore, is to learn to increase our ratio of smart behavior to stupid.

... ... ...

Let me give you one example. Investors tend to think about each stock we purchase in a vacuum, distinct from other stocks in our portfolio. We are happy to realize "paper" gains in each stock quickly, but procrastinate when it comes to realizing losses. Why? Because while regret over a paper loss stings, we can console ourselves in the hope that, in time, the stock will roar back into a gain. By contrast, all hope would be extinguished if we sold the stock and realized our loss. We would feel the searing pain of regret. So we do pretty much anything to avoid that pain—including holding on to the stock long after we should have sold it. Indeed, I've recently encountered an investor who procrastinated in realizing his losses on WorldCom stock until a letter from his broker informed him that the stock was worthless.

Successful professional traders are subject to the same emotions as the rest of us. But they counter it in two ways. First, they know their weakness, placing them on guard against it. Second, they establish "sell disciplines" that force them to realize losses even when they know that the pain of regret is sure to follow.

So in what other ways do our misguided thoughts and feelings get in the way of successful investing—not to mention increasing our stress levels?

... ... ...

hindsight is not foresight.

Wasn't it obvious in 2007 that financial institutions and financial markets were about to collapse? Well, it was not obvious to me, and it was probably not obvious to you, either. Hindsight error leads us to think that we could have seen in foresight what we see only in hindsight. And it makes us overconfident in our certainty about what's going to happen.

Want to check the quality of your foresight? Write down in permanent ink your forecast of tomorrow's stock prices. Do that each day for a year and check the accuracy of your predictions. You are likely to find that your foresight is not nearly as good as your hindsight.

Some prognosticators say that we are now in a new bull market and others say that this is only a bull bounce in a bear market. We will know in hindsight which prognostication was right, but we don't know it in foresight.

When I hear in my mind's ear a voice that says that the stock market is sure to zoom or plunge, I activate my "noise-canceling" device rather than go online and trade. You might wish to install this device in your mind as well.

No. 3 : Take the pain of regret today and feel the joy of pride tomorrow.

Emotions are useful, even when they sting. The pain of regret over stupid comments teaches presidents and the rest of us to calibrate our words more carefully. But sometimes emotions mislead us into stupid behavior. We feel the pain of regret when we find, in hindsight, that our portfolios would have been overflowing if only we had sold all the stocks in 2007. The pain of regret is especially searing when we bear responsibility for the decision not to sell our stocks in 2007. We are tempted to alleviate our pain by shifting responsibility to our financial advisers. "I am not stupid," we say. "My financial adviser is stupid." Financial advisers are sorely tempted to reciprocate, as the adviser in the cartoon who says: "If we're being honest, it was your decision to follow my recommendation that cost you money."

In truth, responsibility belongs to bad luck. Follow your mother's good advice, "Don't cry over spilled milk."

Where am I leading you? Stop focusing on blame and regret and yesterday and start thinking about today and tomorrow. Don't let regret lead you to hold on to stocks you should be selling. Instead, consider getting rid of your 2007 losing stocks and using the money immediately to buy similar stocks. You'll feel the pain of regret today. But you'll feel the joy of pride next April when the realized losses turn into tax deductions.

No. 4 : Investment success stories are as misleading as lottery success stories.

Have you ever seen a lottery commercial showing a man muttering "lost again" as he tears his ticket in disgust? Of course not. What you see instead are smiling winners holding giant checks.

Lottery promoters tilt the scales by making the handful of winners available to our memory while obscuring the many millions of losers. Then, once we have settled on a belief, such as "I'm going to win the lottery," we tend to look for evidence that confirms our belief rather than evidence that might refute it. So we figure our favorite lottery number is due for a win because it has not won in years. Or we try to divine—through dreams, horoscopes, fortune cookies—the next winning numbers. But we neglect to note evidence that hardly anybody ever wins the lottery, and that lottery numbers can go for decades without winning. This is the work of the "confirmation" error.

What is true for lottery tickets is true for investments as well. Investment companies tilt the scales by touting how well they have done over a pre-selected period. Then, confirmation error misleads us into focusing on investments that have done well in 2008.

Lottery players who overcome the confirmation error conclude that winning lottery numbers are random. Investors who overcome the confirmation error conclude that winning investments are almost as random. Don't chase last year's investment winners. Your ability to predict next year's investment winner is no better than your ability to predict next week's lottery winner. A diversified portfolio of many investments might make you a loser during a year or even a decade, but a concentrated portfolio of few investments might ruin you forever.

No. 5 : Neither fear nor exuberance are good investment guides.

A Gallup Poll asked: "Do you think that now is a good time to invest in the financial markets?" February 2000 was a time of exuberance, and 78% of investors agreed that "now is a good time to invest." It turned out to be a bad time to invest. March 2003 was a time of fear, and only 41% agreed that "now is a good time to invest." It turned out to be a good time to invest. I would guess that few investors thought that March 2009, another time of great fear, was a good time to invest. So far, so wrong. It is good to learn the lesson of fear and exuberance, and use reason to resist their pull.

No. 6 Wealth makes us happy, but wealth increases make us even happier.

John found out today that his wealth fell from $5 million to $3 million. Jane found out that her wealth increased from $1 million to $2 million. John has more wealth than Jane, but Jane is likely to be happier. This simple insight underlies Prospect Theory, developed by Daniel Kahneman and Amos Tversky. Happiness from wealth comes from gains of wealth more than it comes from levels of wealth. While gains of wealth bring happiness, losses of wealth bring misery. This is misery we feel today, whether our wealth declined from $5 million to $3 million or from $50,000 to $30,000.

We'll have to wait a while before we recoup our recent investment losses, but we can recoup our loss of happiness much faster, simply by framing things differently. John thinks he's a loser now that he has only $3 million of his original $5 million. But John is likely a winner if he compares his $3 million to the mountain of debt he had when he left college. And he is a winner if he compares himself to his poor neighbor, the one with only $2 million.

In other words, it's all relative, and it doesn't hurt to keep that in mind, for the sake of your mental well-being. Standing next to people who have lost more than you and counting your blessings would not add a penny to your portfolio, but it would remind you that you are not a loser.

No. 7 : I’ve only lost my children’s inheritance.

Another lesson here in happiness. Mental accounting—the adding and subtracting you do in your head about your gains and losses—is a cognitive operation that regularly misleads us. But you can also use your mental accounting in a way that steers you right.

Say your portfolio is down 30% from its 2007 high, even after the recent stock-market bounce. You feel like a loser. But money is worth nothing when it is not attached to a goal, whether buying a new TV, funding retirement, or leaving an inheritance to your children or favorite charity.

A stock-market crash is akin to an automobile crash. We check ourselves. Is anyone bleeding? Can we drive the car to a garage, or do we need a tow truck? We must check ourselves after a market crash as well. Suppose that you divide your portfolio into mental accounts: one for your retirement income, one for college education of your grandchildren, and one for bequests to your children. Now you can see that the terrible market has wrecked your bequest mental account and dented your education mental account, but left your retirement mental account without a scratch. You still have all the money you need for food and shelter, and you even have the money for a trip around the country in a new RV. You might want to affix to it a new version of the old bumper sticker: "I've only lost my children's inheritance."

So here's my advice: Ask yourself whether the market damaged your retirement prospects or only deflated your ego. If the market has damaged your retirement prospects, then you'll have to save more, spend less or retire later. But don't worry about your ego. In time it will inflate to its former size.

No. 8 : Dollar-cost averaging is not rational, but it is pretty smart.

Suppose that you were wise or lucky enough to sell all your stocks at the top of the market in October 2007. Now what? Today it seems so clear that you should not have missed the opportunity to get back into the market in mid-March, but you missed that opportunity. Hindsight messes with your mind and regret adds its sting. Perhaps you should get back in. But what if the market falls below its March lows as soon as you get back in? Won't the sting of regret be even more painful?

Dollar-cost averaging is a good way to reduce regret—and make your head clearer for smart investing. Say you have $100,000 that you want to put back into stocks. Divide it into 10 pieces of $10,000 each and invest each on the first Monday of each of the next 10 months. You'll minimize regret. If the stock market declined as soon as you have invested the first $10,000 you'll take comfort in the $90,000 you have not invested yet. If the market increases you'll take comfort in the $10,000 you have invested. Moreover, the strict "first Monday" rule removes responsibility, mitigating further the pain of regret. You did not make the decision to invest $10,000 in the sixth month, just before the big crash. You only followed a rule. The money is lost, but your mind is almost intact.

Things could be a lot worse.

But some mistakes are deeper and represent failed startegies that are repeated again and again. Among them


Gross underestimation of risks: Inability to understand the actual level of risk

On the plane upon arrival from vacation I overheard a middle-aged dad asking his teenage daughter to use her cell phone to check on Citigroup stock… it was up… they shared in a moment of bonding while talking about being able to watch Jim Cramer’s Mad Money now that they were back in the states (… no joke!)…

America doesn’t just deserve a serious beat down… it NEEDS it.

Our population has lost all respect for risk…

Celebrating the recovery, Paper Economy  Blog, Aug 24, 2009

I give a simple example. S&P500 drop during recent recession at some points exceeded 50%. Diversified bond fund like Pimco drop was around 10%. Does this mean that stocks are just 5 times more risky then bonds. No.  To measure actual risk you need to know the "recovery period": a period during which S&P500 and Pimco will match that amount that you will get in other, more safe asset class, for example stable value fund or short term government bond. The ratio of the lengths of those periods can easily be 100 (3 month vs  20 years in case Pimco vs S&P 500).  That's far bigger ratio then five.  One was to brainwash 401K investors into being super optimistic and this push them to the dangerous highly risky (but very profitable to Wall Street) investment (Super-Myths Optimism, Happiness & Positive Mental Attitude Are Secret Saboteurs, Turning Investors Into Wimps & Weasels, Not Wizards & Winners!)

Chances are you’ve read Napoleon Hill’s classics, Think & Grow Rich and Success Through Positive Mental Attitude, coauthored with insurance mogel Clement Stone.  I did way back when I was at Morgan Stanley in the 1970s. Today, the cult of “Positive Thinking” is very much alive. Look in the business & finance shelves in Barnes and Noble. Still, in the wake of Wall Street’s 2008 meltdown, many began questioning the magic of ”PMA” as they saw their 401(k)s flatline. 

It’ll take more than PMA, mantras, affirmations and a pep talk from the “God Wants You To Be Rich” crowd to rebuild your retirement nestegg. And it’ll take a lot longer than you hope because there’s a “new normal” for the American mind as well as the lower market expectations Pimco’s Bill Gross sees ahead. And it’s not about increasing your optimism level. The meltdown and bailouts left us with enormous anger, frustration, skepticism and mass distrust of virtually everything, including the Think & Grow Rich mantra: “Whatever the mind can conceive, it can achieve.”

Barbara Ehrenreich, the author of Nickel and Dimed, a 2000 bestseller, captures this new mindset in her diagnosis of America’s troubled psyche. Macho male readers may prefer reading the new books detailing Wall Street’s collapse in blow-by-blow real-time TV-style dramas, like Sorkin’s Too Big To Fail. But if you want the psychological “new normal,” step into Ehrenreich’s  office where you’ll dig deep and discover what’s really going on in America’s collective brain. Read Ehrenreich’s Bright-Sided: How the Relentless Promotion of Positive Thinking Has Undermined America.

Yes, ”Positive Thinking” & “Happiness” Are Undermining America!

She pokes huge holes in the myth of positive thinking and its “new age” siblings — optimism, self-esteem, positive psychology and the new “science of happiness” — that are undermining America with false promises of an entitlement of prosperty. In BusinessWeek Michelle Conlin focused on Ehrenreich’s warning to future whistle-blowers in the chapter on “how positive thinking destroyed the economy.” Listen:

“In pre-subprime America, delivering the news that we were all burning down the house was a career-ender. Nowhere was this more true than on Wall Street. One such martyr to the cause of financial realism, Ehrenreich writes, was Mike Gelband, who ran the real estate division of Lehman Brothers. Gelband warned Lehman CEO Dick Fuld about the real estate bubble in 2006. ‘Fuld promptly fired the misfit, and two years later, Lehman went bankrupt’.” Hmmm, isn’t that about the time Paulson left as Goldman’s boss to become Treasury Secretary, later Bloomberg News revealed that Paulson did warn the White House staff of a possible meltdown, still they stayed in denial till it was too late.

Today we know Paulson and Fuld are just bit players in America’s broader ‘positive thinking’ drama, which far more pervasive than the guys at the top of Corporate Amercia and Wall Street. It also infected home builders, realtors, mortgage brokers and millions of homebuyers were all hypnotized, in denial about the risks of defaulting on mortgage payments in event of a down market.

Other critics are equally blunt. Writing in the New York Times Hanna Rosin says “I have waited my whole life for someone to write a book like Bright-Sided. When I was a young child, my family moved to the United States from Israel, where churlishness is a point of pride. As I walked around wearing what I considered a neutral expression, strangers would often shout, ‘What’s the matter, honey? Smile!’ as if visible cheerfulness were some kind of requirement for citizenship,” adding that “America’s can-do optimism has hardened into a suffocating culture of positivity that bears little relation to genuine hope or happiness.” She hesitated to go as far as Ehrenreich who saw a larger conspiracy using positive thinking as ”just another way for the conservative, corporate culture to wring the most out of its workers.” Others were not so reluctant:

“We’re always being told that looking on the bright side is good for us, but now we see that it’s a great way to brush off poverty, disease, and unemployment, to rationalize an order where all the rewards go to those on top,” warns Thomas Frank, Wall Street Journal columnist and author of The Wrecking Crew: How Conservatives Rule. “The people who are sick or jobless — why, they just aren’t thinking positively. They have no one to blame but themselves,” a mindset that echoes the ideologt of many conservatives, religious fundamentalists and hard-core capitalists today.

Read Bright-Sided, it is a perfect psychological counterpoint to typical dramas like When Giants Fall, Bad Money, Panic  and Bailout Nation. You’ll get a shrink’s eye view deep into America’s collective brain. And by jarring you out of denial, it’ll protect you from the new bubble/bust cycle already blowing.

Another problem is that  we are very selective in our information intake and are easily brainwashed by well paid and very slick Wall Street "stock" entertainers.

Most 401K investors have illusions that their returns are higher then they actually are

Many 401K invertors  have absolutely no idea how their investment is doing.  One often overlook problem with "bold" strategies  in 401K plans is that  the same percentage loss in 401K plan means more then each win and losses at the end of investment cycle mean more than wins at the beginning. Suppose you have an investment which earns 20% the first year, -30% the second year, and 10% the third year. What is its average rate of return? It is not the arithmetic mean, because on the first year your investment was multiplied (not added to) by 1.20, on the second year it was multiplied by 0.7, and the third year it was multiplied by 1.1. The relevant quantity is the geometric mean of these three numbers, which is about 0.97 or -3% total return. Cost averaging further complicates the picture: protracted period of abnormally high prices following by a slump can defeat the benefits of cost averaging.

They trust too much to their intuition that is distorted by media noise. As a result many participants in 401k plans are unable "to stay the course" and act spontaneously reallocating their portfolio, and never calculate their total annual return.  In reality average returns are negative after adjusting for inflation and all what those accounts do are feeding mutual funds industry: most (but not all) participants would probably be better off buying Treasuries Direct. In other words they are unable to beat inflation and just serve as "Wall Street donors."

 "Defensive reallocation moves" (and should be not equaled to just selling your stock positions and putting everything in cash) are easy to make only in retrospect. They are for sure a variant of market timing and that latter really isn't that easy of  fool-proof.  That's why a simple dynamic reallocation that includes your age (or the number of years before retirement) matters so much and that fact was now accepted in many "target date retirement" funds, which unfortunately usually are not available to 401K investors.   Essentially it is one slow life-long defensive reallocation move.

Bull/bear reallocation moves to more defensive position in case of bubbles are possible but much more difficult as there are always some mix of real and misleading warning signs before real trouble starts. Often there are multiple signs of troubles are two or even three years before real action starts.  

The key problem here that even real warning signs can come too early and the bull market can run two, three or even five years after the problems became evident and warning signs are abundant. Also a correction of 30% after you gained 40% the previous year is not a disaster. Still if you are determined to play a defensive game you should try to diminish the percentage of stock you hold with age. Please note that cash is safer then bonds, especially if bond funds returns below 5%. The danger of investing in such bond funds was clearly evident in 2007.  Bond funds with returns below 5% are usually bad investment choice in 401K portfolio and cash (ultra-short bonds) is a good competitor as for long term returns.  Therefore there can be some bond to cash rotation if bond yields drop below one percent below this magic 5% threshold (which is actually completely unscientific and you need to understand this).

Some analysts consider 2007 in some ways might resembles 1999 or 1998.  That means that in 2008-2010 we better be really vigilant , even if that just means sticking to 100-your age strategy. History never repeats as a copy and now bonds instead of stocks or along with stocks might be the assets which lose a lot of value. New twists are guaranteed, so experience of 2001-2003 tech stocks carnage  that many still remember well can be only of limited value. If  rates will be raised considerably bonds funds (and especially junk bonds) will suffer most. During 2000-2001 many people including myself  ignored the signs of coming troubles and did not move to a more defensive position (and I remember having this feeling "it is time to reallocate" in Jan 2001 but did nothing and continued to holds 100% stocks till Jan 2002).

It might be partially explained by overconfidence in our own abilities, and information overload with strong "perma-bull sentiment" in Wall Street financed media. Just read  articles and opinion columns of "investment gurus"  from Jan-August 2001: most of them, especially from Jeremy Siegel are pretty funny in retrospect, unless your own money were involved. Here is one telling quote (This Feels Like a Slump, But Is It a Recession? Published: August 15, 2001 in Knowledge@Wharton; please note that the quote has been edited on the original web site since it was originally published ;-) :

Jeremy J. Siegel, a professor of finance at Wharton and author of Stocks for the Long Run, says that "qualitative judgment comes into play whenever one tries to differentiate a slowdown from a recession. My feeling is that we will not have an outright recession or even two consecutive quarters of declining GDP, but the way the economy has slowed is quite substantial. Given the prior euphoria over the new economy, the current deceleration, where growth went from 8% to 2% in the course of a year, feels just like past recessions where growth went from 4% to -2%." Siegel maintains that "events move faster in the new economy, and this can create as many problems as benefits. What must be most disappointing to new economy enthusiasts is the manner in which high-tech firms miscalculated the demand for their products. Sophisticated techniques for keeping inventories low relative to sales may have become commonplace, but even Cisco, for example, was stuck with a huge amount of excess inventory because the speed of obsolescence is so high for computer equipment. Thus, we have learned that the new economy is not immune to old economy issues that create business cycles."

See also his September Is Going To Be the Turnaround interview published on June 12, 2001 in BusinessWeek. As Dante Alighieri in early 14th century suggested in his immortal The Inferno the proper remedy might be:

In life he wished to see too far before him,
And now he must crab backwards round this track

 (Canto XX, Circle Eight--The Fortune Tellers and Diviners)

This is actually a pretty apt vision of the fate of economic and political forecasters.

The myth of diversification

...the high profile commentators ... who have implicitly played their part in marketing and then amplifying this catastrophe might consider quietly entering another field with superior ethics and enhanced value to society at large: perhaps as piano players in brothels.

Diversification across various asset classes is not what 401K investor wants despite being sold as a cure for all ills. Especially obnoxious are attempt to sell diversification as a justification for keeping "all stocks" portfolio in 401K plans. 

What 401K investor wants is not diversification (as correlation between various tock greatly increase in time of crisis) but hedging. It is achievable by keeping a substantial part of the portfolio in stable value fund and TIPS. If, for example you keep 50% of you portfolio in stable value fund and other in S&P500 you losses in 2008 would be more then twice smaller that for those who hold all money in S&P500 fund (or, for a change,  in any large stocks fund).

Overestimation of your abilities and limitations due to greed and brainwashing

This fallacy is actually a part of  the expectation that somebody will provide investors sound advice about what to do with their money.  Ronald Reagan used to quote old Russian proverb "Trust but verify". This proverb is perfectly applicable to 401K investing and the second part is usually completely missing. For example a lot of programmers who are perfectly able to use Excel spreadsheets (and this is a very powerful simulation tool) are investing on autopilot or worse by following some bad advice that they got from the press.

Among typical reasons for low (as in below the inflation rate)  returns [(p. 217) of Reviews for Bull's Eye Investing Targeting Real Returns in a Smoke and Mirrors Market Books John F. Mauldin Gavin McQuill of the Financial Research Corporation list the following":

  1. Fear of regret - an inability to accept you've made a wrong decision, which leads to holding onto losers too long or selling winners too soon.
  2. Myopic loss aversion - a fear of losing money and the subsequent inability to withstand short-term events and maintain a long-term perspective.
  3. Cognitive dissonance - the inability to change your opinion after new evidence contradicts your baseline assumption.
  4. Overconfidence - people's tendency to overestimate their abilities relative to individuals possessing greater expertise.
  5. Anchoring - people's tendency to give too much credence to their most recent experience and to show reluctance to adjust their current beliefs.
  6. Representativeness - the tendency of people to see patterns within random events.

I think that for most of 401k investors the key problem is not "how to get high returns" but "how to avoid zero or negative returns after inflation" and the real task in hand is to squeeze 5% or better 6% annualized return typical for the long term treasury or AAA bonds out of arbitrary mix of investment options present in the particular 401K plan.  With cost averaging, most Vanguard stock funds and indexes that I experimented with (again historical data are not guarantee of future returns) produce returns less then median returns of government saving bonds over most simulations lasting exactly ten years periods with starting dated randomly distributed between Jan 1, 1993 and June 1, 1996  (and those of those set of 10 year periods which end in Jan 1, 2003 to June 1, 2006 most contain both bull and bear markets). And if you think about it, mutual funds are just another type of for-profit commercial enterprises (Vanguard is probably an exception here; but it might be less of an exception then you think).  There are few talented managers who really try their best and a lot of regular guys who have problems beating the index. Otherwise this is just an overhead that you feed and that eats the returns. All you have to do is look at the huge losses taken by popular among professionals and almost universally recommended before 2000 funds like Vanguard PRIMECAP.  Who is recommending PRIMECAP now ?

The idea that dollar cost averaging is an optimal method for contributing to the stock portion of 401K is open to review. In reality dollar cost averaging guarantees lower return then value averaging if the period is large enough.

Published stock indexes returns are somewhat misleading: in no way a typical 401K investor can get those: for ten years period typical annualized return for dollar cost averaging of a certain sum of money is approximately 1.3-1.7 lower then return received by investing lump sum at the beginning of the period.

For example for many "exactly 10 periods"  (say, Jan 1996 - Jan 2006) S&P500 performed worse then stable value fund with fixed return about 4.5% if cost averaging for the whole period starting with zero initial investment is assumed

The idea that your house is a perfect retirement investment

Many “house poor” (middle-class home­owners who stretch themselves too thin financially to buy a large house with the jumbo loan) cannot save enough in 401K because they are slaves of their mortgage loan.  They over-borrowed; worse, they just don’t have enough savings to cushion the impact of a divorce or job loss—two fairly common occurrences.  As a result they can lose house during a prolonged recession.

Former U.S. Labor Secretary Robert Reich noted that assuming that house is essentially "retirement fund in disguise" is open to review:

“Bubbles form when it’s easy to get capital to invest in something, and when investors assume that somebody else will come along after them and pay even more for it.” But Reich warns that when mortgage rates rise—when the easy money dries up—“buyers can no longer assume that future buyers will pay more, because some future buyers won’t be able to.” People can be stuck with more house than they can afford and no way of offloading it.

The idea that home is a safe bet investment is also open to review. It safer then many others types of investment, but only the rich are cushioned from the effects of a housing slump. Less than a fifth of the assets of the top 10% of American earners are tied up in their main homes; for middle class, the equity in houses comprise approximately half of their assets.  An individual mortgage is essentially a huge short position in bonds market. As such it is influenced by bonds yields and behavior of underlying currency. If bond prices go up (and "real", after inflation yield go down) you lose money and if bond prices go down (and "real", after inflation yields go up) you earn money on your short position.

Although fixed mortgage is not callable, they might also be influenced by catastrophic events (as was in case of "Katrina mortgages") and by the depreciation of the currency. Situation is definitely more complex if the annual rate of inflation exceeds 3% (1.03^30=2.42 so with 3% annual inflation means that the dollar depreciates 142% in 30 years; in reality the depreciation of dollar from 1977 to 2007 in relation to euro was faster then 3% a year; but this is not the only measure of inflation). In this case assuming you kept the house for at least 2/3 of the 30-years period "real yield" (after inflation) on the house is much less then nominal yield and you paid the down payment in most expensive dollars. Also the first half of the mortgage is paid in  "old" or "higher value" currency. But when you sell it you will get "depreciated" ( approximately in half) currency for your property. Therefore the price of the house should approximately double for you just to get even. That means that much depends how well the price of the houses kept with inflation. The situation is especially bad if part of the period was consumed by a prolonged housing slump where there in no appreciation (or there is a slight depreciation -- house prices are sticky) of the value of the house. At the same time "stealth" devaluation of dollar also decrease the "real" (let's say converted to gold) interest and as such helps the borrower and hurts the lender.   That's why lender tries to get the lion share of interest as quickly as possible (the first ten years mortgage payments are mostly interest).

Misunderstanding of assets you are invested in

There are two popular delusions: one is that all indexes are passive instruments and the second that bond funds are the same investment asset class as bonds.

Some stock indexes are not exactly passive indexes

Contrary to the popular wisdom S&P 500 is actually a badly managed stock fund. As Professor Siegel noted in his article Old School Stocks Teach New Lessons The Future for Investors - Yahoo! Finance

"By no means is the S&P 500 Index a static group of firms. On average about 20 new stocks are added to the index each year, and an equal number of firms are removed that merge, go bankrupt, or fall below S&P's standards. Over the nearly 50 year history of the S&P 500 Index, almost one thousand new firms have been added and one thousand old firms deleted. "

Overinvestment in stocks (let's say above what formula 100-your age suggests) might be dangerous

Despite all Wall Street financed PR machine higher risk is not always compensated by higher return. Investors in S&P500 now knows that for sure as they lost approximately 30% for the last ten years in comparison with people who put all 401K money in stable value fund. The U.S. stock market is much more risky than most investors perceive it to be and this risk is dramatically higher for short investment periods (let's say periods less then 10 years).  Also there was at least one investment period in the USA history when investors who kept their retirement saving (and other savings) in stock lost everything.  This period was approximately 100 years from now so there are no survives to tell us how it looks like. Still we can rely on written memory and that was not pretty picture.

Without anchor in gold for the nation currency, stocks function more like private fiat currencies of particular companies.  Even with index funds (baskets of currencies) short term declines can be as big as 30%. There is no guarantee that such drop will not happen during your last years before retirement. If so this is a huge blow.  Think about people who retied in late 2002 and have all their money in stocks.  Their investment fully recovered only in 2007 -- five years later.  Changes that they sold it before are pretty high -- my guestimate they are above 80%. Therefore we can guess that only 20% were left relatively unhurt by explosion of dot-com bubble. And those few are probably exclusively concentrated at the higher end on income, where they can rely on other sources of income to wait for the return of good times.

The idea that buying stock is giving you a share of the wealth of the company is completely unscientific. A lot of corporation have outstanding debt that is either substantial part of their assets or exceed their assets. In a later case company stock formally worth nothing:  this is all plain-vanilla confidence game.  That means that like in any Ponzi scheme those who cash out early are the only one who get the benefits of playing the game. That might be early boomers as stocks ownership was grossly distorted by 401K plans demographic. And if demographic is a destiny that can play the decisive role in decline of stock values  (looks at some Senators ramblings about Social Security -- is not that an thinly disguised attempt to find alternative source of buyers for those stocks that will be sold by baby-boomers? ).

Corporate borrowers took advantage of the low interest-rate environment of the past few years to push stocks higher by huge buybacks using for that issuance of new bonds. Some of them overborrowed during the period of low interest rates.  S&P recently warned that slowing GDP growth could squeeze corporate credit quality, which is essentially the estimate of the ability to repay debts.  The recent wave of airlines bankruptcies is just one example. Also it is unclear how assets are valued. Viewing stock as a fiat currency of a particular corporation and stock market as a giant pool of currency speculators (including you and me) betting on the strength of different currencies (and sometime manipulating them) to extract a profit might be a more realistic vision of  the current situation then fairy tales about ownership. 

Like in case of currencies the stock market is one of the few marketplaces on earth where people become more excited to buy when things are expensive, and more anxious to sell when things are cheap. Moreover there is some evidence that punch cup of monetary expansion (using money printing press to stimulate the economy) will be more difficult to serve after Greenspan. Events in 2007 more and more look like a credit crunch. If this is true there is no guarantee that in ten years' time the US stock market might be  significantly higher than it is now as rise of stock market is a side effect of huge monetary expansion under Greenspan, expansion which links to the huge extraction of wealth from former communist countries (dollarization of former Soviet block).  This was a one time historic event, which is mostly over and some recipients of this largeness are not happy. Former communist countries were successfully converted into new Latin America and like in Latin America most countries in the region are turning more and more anti-American. There is not much that can be done after that.

Again demographic matters in a sense 401K plans became baby boomers large Ponzi scheme in which only whose who rush to the exit first might preserve wealth. Some experts predict that  stock market can stagnate sooner then the major wave of boomer retirements hits the market (2010) as behavior of stock market correlates not only with the state of economy and the pace of monetary expansion but also with the percentage of the population aged 45-55.

We need to take into account the possibility of a modern variant of a Ponzi scheme ("rob-Peter-to-pay-Paul") in 401K plans for boomers.  That might mean that early boomers can get out relatively unhurt, but later folks might have difficulties with offloading "overstocked" portfolios as there might be less demand for stocks from subsequent, numerically weaker,  generations and if dollar will continue its slide from foreigners.   Of course this is a mere speculation (like any economic prediction) but this might in a significant way to affect your lifestyle after retirement and some prudence is advisable.  Excessive greed (aka "appetite for risk") now might hurt your well-being in later years.

My hypothesis is that by overloading 401K portfolio with stocks, let's say, percentage-wise above the number dictated by  the (100 - your_age) formula  investors are taking disproportional higher risks why enjoying pretty low chances of  sufficient reward in the form of higher returns. You need to be aware that this is a just a hypothesis by a non-specialist and treat it with cautions it deserves:  there are just too many gurus who claim to be able to predict the future. Also economics are a breed which "is often in error but never in doubt" and here I am wearing an economist hat.

One (weak) heuristic argument in favor of this hypothesis is that it holds in simulation experiments that I performed with some stock-bond mixes with holding period of ten years, cost-averaging contributions for this period (starting from zero capital) and random starting points in 1990-1996 range.  Mixes closer to 50% (even static mixes) generally behaved better for those periods. And those risks might be even bigger that simulation on historical data suggests if we take into account financial excesses of both Clinton and, especially, Bush II administrations (as Dick Cheney quipped "deficits does not matter"; in a way he was right as real goods were purchased for fiat currency). Not that other risks are small.

Of course gloomy forecasts like any forecast can be wrong and stocks well can provide above average returns as they magically started providing in 2003 after two years of huge losses. Still blindly investing in the mix of stock funds and assuming that the future is always going to be rosy is a risky strategy.  The closer you are to retirement the less time you have to recover from one substantial loss due to a sharp stock market decline. As 2001-2002 experience had shown, no "financial alchemism" (search for "philosophical stone" which magically turns lead into gold -- a perfect stocks funds mix) fundamentally changes the risks involved in all stock portfolio.

Economists regard state lotteries as a voluntary, implicit regressive tax. That's because the poor pay a larger proportion of their incomes on lottery or scratch tickets than more prosperous gamblers do. Playing with stock funds in 401K accounts became similar to lotteries for many professionals.  Brainwashing by strong "perma-bull sentiment" in the investment banks controlled media outlets suppresses critical thinking. And we all need to remember that it is the financial industry which is paying for this "perma-bull" circus on CNBC and they are only happy to rake in their billions each year, but at what cost to society?

It is very difficult not to be influenced by the bubblevision, perma-bullish cheerleading for the markets and adopt defensive positions in 401K

Mutual funds industry has huge influence and associated large sector of financial media is advocating mostly stocks portfolios (stock mutual funds represent the dominant share of mutual funds). But without taking into account your age and market conditions aggressive use of stock funds makes the success of your retirement plan rests on dumb luck. If you need to retire during significant and prolonged market slump, you can face a loss of up to a half of your holdings as those who did this in mid 2002 -- early 2003 discovered.  This can be called "Great American Casino named after Chairman Greenspan". And many otherwise very reasonable people have natural tendency to gamble with their money in 401K accounts. In 1999, a National Gambling Impact Study Commission estimated that approximately 5 million of Americans can be classified as "pathological or problem gamblers", with an additional 15 million at risk.  While those probably do not have 401K accounts anyway,  with stock funds (like in any casino) not only  "pathological or problem gamblers" are at risk. After all your participation in 401K is by all accounts a short run -- nobody particulates in it for 50 years.

Stocks as fiat currencies

Let's assume that stocks are fiat currencies of private companies and due to complexity of accounting in large corporations it is unclear how financially stable they. that means that P/E ratio are fake and while high P/E ratio are a warning sign, normal or low P/E ratio guarantee nothing.

Bond funds suffer from other set of problems.  Here the main danger is the middleman, the broker who wants 20% or more of profits.  Even low cost Vanguard, Fidelity bond funds as well as institutional shares of Pimco funds (or other no load fund families) that are typically present in 401K portfolios probably are adding up to 0.25-0.5% a year in expenses to inflation losses (Pimco institutional Total Return shares have expense ration  exactly 0.5% which is 20% or more of average return, Vanguard adds less then that).  

Whoever has or is given the authority to create credit has the authority to extract wealth from the economy by that same mechanism. The bankers are, in other words, redistributing the wealth of the USA. Thomas Jefferson  once noted that "...banking institutions are more dangerous to our liberties than standing armies...". In some aspects bond mutual funds are very close to banks. It is prudent to view economics as an ecosystem, and, as such, it should contain class of economic parasitizes.  That means that you are lucky if you preserve your money as some funds (for example Pimco) that have high expenses and substantial share price volatility.

John Fuchs was checking his 401(k) account online one afternoon when he saw something that seemed amiss. Listed along with his regular contributions was a $48 charge, in red. That's odd, he thought. Why would anyone be taking money out of his account?

After a flurry of phone calls and e-mails, Fuchs learned that the $48 deduction was no mistake. The money was paid to an outside firm that enrolls employees in his company's 401(k) plan, mails quarterly account statements and handles other administrative tasks.

While $40 a month is rather uncommon (you probably need to have at least $500K in a typical 401K account for this), $10 per month is pretty common. If we assume that account contains only bond funds and the dividend from bond funds is, say, $500 a month, they are deducting additional 2% of dividends each month. This is so called "Plan administration fee".   It is unclear why those fees are proportional to the total of your investment as they generally should be fixed on the same level per participant no matter how many money he/she have in the funds.   For example those banks who charge feed for maintaining your checking account never change fees based on percentage on your assets.

One of the major factors in  "stocks over-consumption" by 401K investors is probably aggressive selling by Wall Street.  That can result in adoption (brainwashing or all money of stock 401K investing) or negative reaction that can go to the other extreme (gold bugs and all bond/money market investors). We will discuss the strategies one by one below starting with the so called "Fashionable mix" strategy.



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