The 7 Deadly Sins of 401k Investing

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401k Investing Mistakes to Avoid

Access to the stock market and all its wealth and wonder is not without pitfalls, as the beating many of us took in the 2008-09 banking meltdown proved. Many folks with 401k investing plans got sucked into common mistakes that actually put their finances in worse shape and threatened their retirement prospects.

We can sum up many of those 401k investing mistakes in terms of the classic seven deadly sins. They’re serious offenses, and committing just one of these mistakes too often can condemn you to a subpar retirement. But thankfully, there are ways to find absolution and fix things before it’s too late.

NEXT – Wrath

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401k Investing Sin #1 – Wrath

We all get angry at little things from time to time, so it’s natural to get fired up either with yourself or with your fund manager when something goes awry with your hard-earned retirement account. But if you let that anger consume you, it can cloud your investing judgment.

Let’s say you joined a company in 2000 and dumped your 401k contributions into a number of Fidelity funds[1] — for instance, Fidelity Magellan (FMAGX[2]), Fidelity Diversified International (FDIVX[3]) and Fidelity Small Cap Growth (FCPGX[4]). At the market’s bottom in March 2009, you flew off the handle and bailed out. Over that period, Magellan had plunged by 75%, Diversified International had tacked on a measly 9% and Small Cap Growth had fallen 35%.

Only it’s not that simple. First off, the losses probably weren’t that bad. Say you didn’t put your entire account together at the peak on Day One of your new job but paid in over time. That means you bought on some dips along the way. There would also have been regular distributions — a sort of dividend payout for mutual fund investors. So it wouldn’t have been as bad as it looked at first glance.

Meanwhile, bailing out would have come at a significant cost. The obvious loss would have come from missing out on stocks’ rebound by going to bonds or cash. Since March 9, 2009, Magellan has gained about 90%, Diversified International about 75% and Small Cap Growth more than 100%. On top of that, if you had cashed out your 401k, you’d have to pay income taxes and penalties on the early withdrawal that could eat up a quarter to nearly half of your money.

Obviously, wrath gets you nowhere and leads to bad decisions. Take a deep breath and think rationally before pulling the trigger.

NEXT – Greed

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401k Investing Sin #2 – Greed

In this era of day trading and fast-paced Wall Street transactions, it’s easy to make the mistake of thinking your 401k is a brokerage account[5]. But that simply isn’t true. Mutual funds are not designed for short-term trading to chase the flavor of the month but rather a long-term strategy that takes macro trends into account.

The fact is that you’re buying a mutual fund because you believe in the manager and the philosophy of the fund. If you think you’re a better money manager, that’s fine, but strike out on your own with a brokerage account. And realize that your pursuit of bigger profits in the next hot stock comes with a high price tag: taxes paid on the front end for any cash from your paycheck you put into the market and taxes on the back end on any profitable sale you make. And let’s not forget that your employer isn’t going to match your monthly contribution to a personal E-Trade account.

The bottom line is that even if you manage to make better decisions than your 401k fund managers, you’ll really have to knock it out of the park consistently to offset the tax burden. Don’t get greedy or hyperactive with your 401k. Make informed long-term decisions, and don’t micromanage your portfolio.

NEXT – Sloth

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401k Investing Sin #3 – Sloth

On the other end of the spectrum, there are lots of folks out there who take the “set it and forget it” approach to 401k investing. This sometimes works out but more often leads to disaster. It’s almost impossible for any fund to remain dominant for several years, let alone several decades.

Let’s go back to the example of joining a new company in 2000 and firing up your 401k. The federal funds rate had just been increased to 6%, and the bond market was looking good, so you opted to dump a portion of your cash into the Vanguard Long-Term Bond Index Investor (VBLTX[6]) and the rest into Vanguard Total Stock Market (VTSMX[7]). These were low-risk, long-term bets, so you let your 401k ride.

But while Long-Term Bond had a great time in the early 2000s, it ran out of gas at the end of the decade. Overall, the fund is up a mere 13% in 10 years (not counting distributions). Total Stock Market is down by the same amount, making this combo basically a wash after dividends.

By doing just a little homework — checking up on interest rates or bond yields to judge your investment in the bond fund, for instance — you could have made a significant difference in your nest egg.

But perhaps the worst instance of 401k sloth is folks who not only let their funds languish but don’t even bother to maintain them after they switch employers. Leaving a 401k behind when you switch jobs is foolish, because you are no longer bound to old restrictions of your previous employer. Anyone able to roll those funds over into an IRA with a wider selection of investment options should jump at the chance.

So don’t be a 401k slacker. Assess your portfolio regularly to take stock of what’s working and what’s not — once a year at the least and every quarter ideally. And if you switch jobs or have the chance to roll over an old 401k into an IRA, don’t hesitate. It’s your money, and it’s up to you to put it to work.

NEXT – Pride

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401k Investing Sin #4 – Pride

All self-guided investors have been guilty of pride. We love to tout our accomplishments, and we love to cling to failures on the belief that our choice was a sound move that will eventually turn around.

But pride has serious consequences for your 401k if you’re not careful. When a fund turns south or economic conditions change, you have to have the discipline to admit a mistake and move on. After all, there’s no extra cash prize awarded at retirement for stubbornness.

Let’s use our previous example once more: You start a 401k in 2000, and, having great faith in the booming real-estate market, you dedicate some of your cash to the T. Rowe Price Real Estate Fund (TRREX[8]). Things are going great. The fund more than triples in seven years, and you start bragging to your friends about how smart you are.

Then, after the peak in 2007, the bottom falls out. People start to talk about subprime lending, no-doc loans and mortgage-backed securities. Gloomy housing headlines get darker as the months roll on. But even while your real-estate fund slides 30% over the first six months of 2008, you hang on out of pride.

We all know how this one ends. Refusing to admit you made a mistake in a bad fund or riding a good fund are common mistakes of prideful 401k investors. Know when to say when, even if it hurts your ego.

NEXT – Lust

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401k Investing Sin #5 – Lust

Falling in love with the manager of one of your mutual funds because of previous rock-star performances is a common but fatal 401k investing mistake.

First off, past performance is in no way a guarantee of future success. And secondly, some of the best in the business are painfully aware of their prestige and think it’s OK to gouge investors with fees. You might think, for instance, that a 2% annual fee is low. Except a fund that returns 7% every year is a pretty good investment in the mutual fund universe. Giving up 28% of that return is a punishing premium to pay and can really affect your 401k over the decades.

And here’s the kicker: Most researchers agree that funds with low expense ratios actually outperform their expensive brethren — so it’s not like the higher cost means higher quality.

So don’t let your lust for a sexy manager blind you. Though some managers are worth the hype and may be perfect for your portfolio, not every pretty face is a good fit.

NEXT – Envy

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401k Investing Sin #6 – Envy

Jumping into a trendy investment because your neighbor has enjoyed big profits is another common 401k investing mistake. Worrying whether the grass is greener on the other side of the fence leads many folks to jump into fad investments that are flaming out or funds that may not be right for every nest egg.

Take the Legg Mason Capital Management Opportunity Trust (LGOAX[9]), which returned more than 80% to investors in 2009. That’s good — except this fund makes its money investing in derivatives and other financial instruments. Those are the risky investments that led to the financial crisis in 2008, and this fund could surely swing the other way just as severely if those instruments become troublesome again. It’s also worth noting that the Legg Mason fund was launched in February 2009, so there’s no way to judge how it does in bad times. Its only historical data involve the two weeks before the market’s bottom in 2009 and the bull market run since then.

But if all you’re paying attention to is a co-worker who’s bragging about his 401k portfolio, you may not know any of this — and may move your money in so you can join the party.

Don’t make that mistake. Do the research before switching funds, and remember that past performance never is proof of future returns.

NEXT – Gluttony

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401k Investing Sin #7 – Gluttony

Though diversification is important, you don’t have to own every fund your 401k administrator offers to spread out your risk. Mutual funds are already a basket of many stocks or bonds, so there’s no need to go overboard. Six or seven funds should be plenty.

It’s also worth noting that an unwieldy 401k is not only harder to keep track of and manage but also will likely limit your returns because each fund is going to take its cut in the form of fees.

It’s also worth noting that even if you limit yourself to a handful of mutual funds, your 401k can be the victim of gluttony in the form of multi-management. Too many cooks can still be in the kitchen.

Take the Vanguard Windsor II Fund (VWNFX[10]). In January, Vanguard announced that it was handing an 8.5% piece of Windsor II to Sanders Capital and, in particular, John Mahedy, who had worked on the original Vanguard Windsor Investor Fund (VWNDX[11]) when he was at AllianceBernstein. Unfortunately, rather than give Mahedy and his team a mandate to run a value fund, Vanguard is simply continuing to add chefs to the Windsor II kitchen.  So far, more managers haven’t improved results.

Vanguard, like many mutual fund companies, claims that multi-managers add to diversification. But a good portfolio shouldn’t have to rely on multi-management to achieve that — because what Vanguard can’t point to is improved performance from its multi-managed funds.

Low risk doesn’t have to mean low returns. If you’re a glutton for funds or a glutton for managers, you may be diversifying your portfolio right out of the profits you deserve.