401(k) Let You Down? Check the Allocation

Now that the final figures are in, we know exactly how well mutual funds and stock market indexes did in the second quarter.

Many did extremely well. But the question, of course, is how are you doing?

Since many Americans have the majority of their financial investments in an employer-sponsored 401(k) retirement plan, they will know how they did in the coming weeks as quarter-end statements arrive in the mail.

Don’t be surprised if your account saw only single-digit gains over the last three months, despite the double-digit increases for many of the world stock market indexes, financial planners say.

“You may be disappointed,” says Ridgewood, N.J., financial planner Paul Westbrook. “But don’t worry about that.” The important thing is to understand why your 401(k) investments performed the way they did, and whether the performance is consistent with your long-term investing plan.

For some investors, poor quarterly results may be the result of picking one or two bad funds. Or loading up on company stock that didn’t do so well.

But by and large, it’s your overall asset allocation decisions that determine your returns--in other words, how much you have decided to invest in stocks versus bonds versus cash--and which categories of stock funds and bond funds you choose to invest in.

Hewitt Associates, a Lincolnshire, Ill.-based employee benefits consulting firm, tracks the activities of 401(k) investors through its Hewitt 401(k) index.

In the second quarter, it found that the nation’s 401(k) investors continued to put more money into large-cap stock funds, which were already the most popular type of mutual funds within 401(k)s.

Meanwhile, overall investments in small-company stock funds and international funds remained tiny.

In fact, at the end of May, 401(k) plan participants overall had only 3.4% of their account balances in international stock funds, Hewitt figures show. And even less--1.2%--was invested in small-company stock funds.

Yet, to have made significant gains during the second quarter, investors probably needed to have a decent stake in either small-stock or foreign funds.

Popular large-growth-stock funds, while they made money, advanced a modest 4% for the quarter. By comparison, the average small-value-stock fund advanced 17.9%, and the average emerging-markets stock fund surged 25.7%.

Now, before you get mad at yourself, or begin to doubt the wisdom of your asset allocation, realize that the situation may not be your fault. For instance:

* Some 401(k) plans don’t offer small-cap stock funds as investment options. In fact, nearly half of all plans fail to offer even a single small-cap fund, according to a recent survey of employers by the New York-based employee benefits consulting firm Buck Consultants.

So even if you wanted to invest in one through your company-sponsored plan, you might have been unable to.

* Some plans don’t offer international funds as investment options. Three out of 10 plans still don’t, according to the Buck survey. And of those that do, only a minority offer an emerging-markets fund. Instead, most plans offer a plain vanilla diversified foreign stock fund, which tends to invest largely in Europe.

And Europe-oriented funds would not have done you much good in the second quarter, given the region’s economic slowdown and currency woes. In fact, Europe funds ranked as the second-worst category of stock funds during the quarter, with gains of just 1.6%.

* Your time horizon and tolerance for volatility may limit your risk-taking ability. Emerging-markets funds (and, to a lesser extent, small-cap funds) may be an inappropriate investment for you, given your situation and their relative degree of risk.

In fact, some financial planners, like Ron Roge of Bohemia, N.Y., generally advise clients to avoid emerging-markets funds altogether.

Now, if you’re still concerned about your asset allocation in wake of the second quarter’s returns, there are some things you could have done differently to perhaps have boosted your results. Among them:

* You could have routinely re-balanced your portfolio. Many financial experts recommended that investors do this at the start of the year. Did you?

Chances are you didn’t, because most individual investors don’t even know what re-balancing is.

Re-balancing is a simple process in which you determine what your long-term asset allocation ought to be. Then, once a year or so, as your actual investments stray from that allocation due to market forces, you readjust your investments to reflect the original plan.

For instance, in 1998, large-growth stock funds were the market leaders by far. They advanced 36.5%, on average, during the year. Small-value-funds, on the other hand, lost 6.9%.

So, assuming you started the year with a 70%-30% allocation to large-growth stocks and small-value stocks, respectively, that allocation would have drifted to 77%-23% by year’s end.

By re-balancing at the start of this year, you would have trimmed back your large-growth fund stake and shifted the proceeds into small-value funds.

“If you had just done this typical, routine maintenance, you would have been rewarded this quarter,” notes Meloni Hallock, a partner at Ernst & Young’s financial counseling group in Los Angeles.

Psychologically, of course, it’s always hard to sell winners to buy a bigger stake of losers. But, by doing so, says Hallock, you are buying low and selling high--and avoiding the opposite.

* You could have avoided chasing “hot” funds. If ever there was a quarter that proved the hazards of trying to chase hot funds, it was this one.

Last year’s hot stock funds included such names as Janus Twenty, PBHG Large Cap 20 and Legg Mason Value. Each was up about 50% or more in 1998. In the second quarter of ‘99, though, these funds fell 4.3%, 0.9%, and 0.4%, respectively.

* You could have been more patient with the funds you own. Patience paid off for many 401(k) investors this quarter.

For instance, among those funds most commonly found in the region’s and nation’s 401(k) plans, last year’s laggards included Templeton Foreign, Vanguard Windsor and Neuberger Berman Guardian. In the second quarter, these funds were among the leaders. They were up 15.6%, 13.8% and 11.2%, respectively.

While the vast majority of 401(k) investors refrain from moving money around often, “you do see small clusters of participants who are very active,” oftentimes more active than for their own good, says Lori Lucas, a consultant with Hewitt in charge of its 401(k) index.

Greg Schultz, principal with Asset Allocation Advisors in Walnut Creek, Calif., asks an important question: “Do you change your investments or investment philosophy based on one quarter’s worth of performance?

“Of course not. That’s stupid.” Plus, he says, “anybody who’s up 8% or 10% year to date, if they’re grousing about their returns because somebody else got 20% investing in something else, they’ve got other things to worry about, like false expectations.”

Westbrook agrees.

He says it’s dangerous to make changes to your 401(k) plan every quarter just because you didn’t enjoy the absolute highest returns. “If you play that game, you’re going to be behind the eight ball.”

But given the market rotation we saw during the quarter--from large stocks to small, from growth stocks to value and from domestic stocks to foreign--what should you do going forward?

Instead of shifting money based on what was hot last quarter, take Hallock’s advice. Determine what the most appropriate asset allocation is for you--given your income needs, time horizon and risk tolerance--and structure your portfolio to meet that plan.

If you’ve already done that but haven’t re-balanced in more than a year, think about doing it now. There’s a good chance you’re still overweighted in large-cap stocks, despite the recent out-performance of small- and mid-cap funds.

*

Paul J. Lim can be reached by e-mail at [email protected].