A default investment fund is what you get when you can't make up your mind what to invest in, as in a 401(k) plan. The most popular default fund today is the target retirement date fund, promoted as a fund you can ignore (default to) since its portfolio is adjusted automatically as you get closer to retirement. But ignoring it through market cycles can cost you.
You may own a target retirement fund if you’re in a 401(k) plan and you signed up but didn’t pick a fund to invest in or you were automatically enrolled. This kind of fund is also popular with beginner investors because it is promoted as a “one-decision” fund – it adjusts its investments to become more conservative as you grow older and closer to retirement. The theory -- you don’t have to do anything -- is great. But the theory is flawed.If you’re 25 or younger, your target fund will have a date like 2050. At this distance from retirement, the fund will be predominantly invested in stocks, so an investor needs to understand market cycles or trends to make the most of this investment. You face two problems and an opportunity.The first problem is doing the wrong thing: Buying high and selling low. This happens when you let your emotions make your decisions for you. In a market decline, for example, which happens on the average every four and half years, investors are faced with seeing the value of their accounts fall with each monthly or quarterly statement. Finally, you feel so much pain – you sell just to stop the pain. You have locked in a loss, real money, and now must start over again.The second problem is doing nothing and riding out the market’s cycles.Since 1942, the average bull market in stocks has lasted 4.4 years and produced a return of 149.5%. The average bear market has lasted 1.1 years and produced a loss of 30.57%. So let’s consider: On average, 2 bull markets + 2 bear markets = 11 years:If you start with $10,000, and are lucky enough to invest at the beginning of a bull market, in 4.4 years your account is worth $24,950. Along comes the bear market and 1.1 years later your account is down to $17,323. The next bull market takes your account up to $43,221 and the next bear market shrinks it to $30,009. That is a 200% return (($30,000 / $10,000) – 1) or an annual average return of 18.18%. Not bad at all.But consider how much bigger your account would be if you missed just half of each of those two bear markets. Why half? Because no one is able to sell exactly at the top – at the highest price – or buy exactly at the bottom – at the lowest price. So let’s say you sold too early and bought too late and cut the impact of the bear market down to –15.25%.At the end of those 11 years – 2 bull markets + 2 bear markets – your account would be worth $44,714. Your bull market gain is identical. But reducing your bear market loss to –15.25% results in an account value 49% bigger. That’s a 347% cumulative return or 31.55% average annual return. That’s better than good.This data began in 1942. You could argue that it encompasses the entire post-war boom – and baby boom – economy. That’s true, and what that means is that future bull markets may not be as good and future bear markets may be worse. Which makes this advice more important than ever.Some people would say that I’m recommending market timing, which I’m not. The fallacy to market timing is that you can predict what’s going to happen. You can’t. But you can follow market cycles or the primary trend. It’s going to change once every five years, on the average. Is that so hard to keep track of?Stock market data courtesy of Bespoke Investment Group.
Andy Mayo helps beginner investors, or anyone frustrated, uncertain, or confused about stock market investing, make money consistently by using the Essential Pivot. He blogs at www.extramayo.net.
