Imagine this: Person A’s 401(k) grew by 25% last year. Person B’s 401(k) only grew 10% that same year. Does this mean Person A is the better investor?
Battle of the 401(k)s: Mary vs John
Mary, a 28-year-old salesperson, told her father that her 401(k) returned more than 25% in 2013.
“How did you do last year, dad?” she asked.
“We gained 10%,” replied her father John, age 65. “That’s just fine for your mother and I.”
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At first, Mary laughed thinking she was a smarter investor than her dad. But then she remembered a similar conversation she had had with her dad in February 2009. His 401(k) only ticked slightly down in 2008, the year of the biggest stock market crash since the Great Depression. Here account suffered a loss of more than 30%.
Comparing Apples and Oranges
Mary and John’s story underscores an important truth: Comparing your 401(k)’s performance to another plan, which is built around a different set of goals and risk considerations, is like comparing apples and oranges.
Mary is not “doing better” than her father--or vice versa. They are in different life stages with varying timelines and risk tolerances. As a result, they have a different asset allocation in their portfolio.
Both Mary and John need to evaluate their portfolios on their own terms, which is a two-step process. They must do a top-down review of their overall asset allocations, followed by a bottom-up evaluation of the performance of each fund they’ve selected.
Diversification adds real, measurable value to portfolio performance. Individuals’ portfolios should be aligned with their goals and tolerance for risk, and these factors will change as retirement draws near. That’s why Mary and John had such different results in 2008 and 2013.
Mary had a higher allocation to riskier, growth-oriented assets. She has enough years left before leaving the labor market to recover from the risk of a steep downturn. John, who is much closer to retirement, had more safe-haven assets like bonds. That’s why his portfolio returns didn’t suffer as much from the crash of 2008, and why his return was lower in 2013.
When Mary and John conduct a “top-down” review, they should ask themselves: “How did my portfolio as a whole perform?” Then they should see whether or not their portfolio performed in-line with its design. If their allocation no longer fits their circumstances, they can modify their allocation to reflect their new situation.
A bottom-up evaluation means taking a look at the performance of each fund in a portfolio based on the individual funds in each class.
For example, Mary may have large-cap, small-cap, developed markets, emerging markets, and bond funds. She should compare her individual fund performance to a representative benchmark.
The S&P 500 or the Russell 1000 can serve as a large-cap benchmark. The Barclays U.S. Aggregate Bond index is widely used as a benchmark for bond funds, and Morgan Stanley Capital International (MSCI) runs a wide array of international stock benchmarks. Mary should compare the returns of her funds against those benchmarks.
Mary and John should also look at their “risk-adjusted return,” which represents the types of returns they’re enjoying relative to the risk they’re carrying.
The Sharpe Ratio measures an asset’s return (above a risk-free rate like Treasury bills) divided by its standard deviation (a common measure of risk) for the same period. This is one of the best ways to track “risk-adjusted return.”
If any funds in an asset class are not performing well against the benchmark, it is time to see if there are better options within the 401(k) plan.
No Free Lunch
In investment markets, as in life, there is no free lunch. Investors need to decide how much risk they’re willing to accept in pursuit of a greater return. This trade-off is reflected in both Mary and John’s portfolios.
Mary is right to have a higher slice of risky, growth-oriented assets -- but she will have to endure some bumps along the way.
John also has to make trade-offs. He will start drawing annual income from his 401(k) next year, so he cannot pursue aggressive growth. But he still needs returns that can (at least) outpace inflation, and perhaps enjoy modest growth.
Every person’s 401(k) portfolio performance should reflect their specific situation. It doesn’t matter how a child’s portfolio compares to a parent’s plan or a best friend’s plan, or even a colleague’s plan.
What does matter? Two things: whether or not a portfolio is delivering the mix of growth and income that the owner is targeting, and whether the returns are reasonable, relative to the mix of assets involved.
In short: Investors need to design a portfolio around their goals and risk levels and then make sure they’re getting returns that are aligned with that design.
Disclaimer: The persons and performance figures referred to in this article are fictional. They are for illustrative purposes only and make no representations about actual past, present or future performance opportunities for any actual investment strategies.
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