An Unnecessary Gamble
One of the most common mistakes made in the retirement vesting world, particularly among 401(k) participants, is over-concentration in an employer's stock. In an analysis of more than 100,000 401(k) participants from companies offering stock in their 401(k) plan, more than 54 percent of employees had stock concentration levels that were greater than 20 percent of their total account, an amount that is enough to significantly decrease their median forecasts.
In fact, loading up on your employer stock is even worse than loading up on a random individual security. Why? Because chances are your job (and hence your future income) is likely to be highly correlated with how the company stock performs. If bad things happen to the industry or the stock of your employer, you are likely not only to lose your money on the investment, but possibly your job as well.
As the unhappy
former employees of Enron can attest, this double whammy effect can be
devastating, particularly if you are nearing retirement. This implies that
you should be even less likely to want to hold the stock of your employer
than you would be to hold the stock of a random company. Unfortunately,
surveys suggest that many employees do exactly the opposite, loading up on
their employer stock in their retirement plan.
To determine that something is undervalued, you have to have
information about the future prospects of the firm that are not understood
by the market. If it is public, you can bet that the markets have already
digested the information. If the new information is private, you are
prohibited by law from trading on it (this is called insider information).
Never make the mistake of assuming that a great company implies a great
The genie states that there would be many bumps along the road, but the investment was guaranteed to have average annual returns of 37 percent. The investor does a quick calculation in his head and determines that if he invests $100,000 in the stock and gets an average annual return of 37 percent, then he stands to make about $560,000 over the next six years. Not a bad deal, right?
there will be some volatility, but those guaranteed average annual returns
look pretty good. The investor thanks the genie and promptly goes off to
invest his $100,000 in the recommended stock.
This is an extreme
example, but clearly demonstrates the danger of focusing too much attention
on average returns without considering the impact of volatility. Remember
that volatility matters a lot in accumulating wealth over time.
Jones has led the investment management function at Financial
Engines for more than a decade. He holds an MS in business technology, an MS
in engineering-economic systems, and a BA in quantitative economics, all
from Stanford University.
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