Remaining inactive in the stock market is one of the keys to investing. There is an increased probability of error when looking at the stock market when prices are setting new lows or highs. A better idea; find something to take your mind off of the “noise” in the financial markets. Warren Buffett of Berkshire Hathaway plays bridge and his partner Charles Munger works on his mental models to fill the time. Challenge yourself to delay decisions at least one day, as this is an effective tool for investors to make sound decisions. Warren Buffett once said, “It is better to do nothing at all than to do something stupid.”
According to the most recent Hewitt 401(k) Index, the equity allocation in 401(k) plans in March 2008 declined to 63% from 68% one year earlier. Moreover, it was accompanied by abnormally heavy volume, the most since the index began in 1997. The beneficiaries were three fixed income classes; money market, bond and stable value funds. Rather than focusing on the long term nature of this critical retirement asset, investors are letting short term fluctuations and their psychological tendencies overwhelm them. Investors take comfort in a misguided sense of being proactive and safe. In reality, they historically have buried themselves in lower volatility (and low yielding) holdings at the point of maximum pessimism...and impaired their long term financial security.
Reacting by moving to cash upon receiving a retirement plan statement that has lost value is the most common mistake. Soon thereafter, these investors naturally begin to ask themselves, “I am watching my retirement account evaporate…should I even continue to contribute?” At first glance, this appears to be a reasoned approach but the reality is counterintuitive. When prices are lower, that is the best time to contribute new money. In short, long term investors should hope for periods of falling prices for it allows them to put capital to work at more advantageous prices!
Do not break your habit of regular savings. The technique of saving a regular amount over different interval (commonly every month or pay period) is referred to as “dollar cost averaging”. This is a disciplined approach that helps to reduce the risk of investing a large sum at an inopportune time. Let the math work…and focus on the long term nature of your deliberate wealth building.
Disclosure: Systematic investing does not assure or protect against loss in declining markets. Investors should consider their ability to continue to purchase through periods of lower price levels.
The most troubling trend is that borrowing from retirement plans is surging. According to a February 2008 study from the Transamerica Center for Studies, at the end of 2007, 18% of workers had loans against their retirement plans, up from 12% at the end of 2006. Further, two of the largest 401(k) plan providers recently reported double digit increases in requests for hardship and non-hardship withdrawals. While these withdrawals do not need to be paid back, they are especially costly because they are subject to taxes and penalties. (Often those costs will consume half of the amount withdrawn.) It is likely a sign that cash-strapped consumers are raiding their nest eggs to stay afloat, no longer able to access home equity or their credit cards which are at their limit.
Setting aside the clear lack of financial planning fundamentals such as living below your means and having a cash reserve of 3-6 month of your expenses…it brings us to the important economic principle of “opportunity cost”. This can be defined as; “The cost that must be forgone in order to pursue a certain action.” In other words, the benefits you could have received by taking an alternative action. Let’s consider the financial impact for two 38 year olds who intend to retire at age 65. Here are the potential outcomes for the two investors:
- Because of a short-term financial crisis, Investor A needs $5,500 to pay off a credit card balance. The only option available is to withdraw the funds from his retirement plan. In order to “net” $5,500 after taxes and penalties, a premature withdrawal of $10,000 is required.
- Investor B has a sufficient cash reserve and lives below her means. She does not need $5,500 in cash and does not make a withdrawal of $10,000 from her retirement plan…instead leaving it invested in a high-quality, diversified portfolio.
What is the opportunity cost of that $5,500 to Investor A? By inverting the question, the more appropriate question is; “In retirement, how much could that $10,000 have grown for Investor A?” If the portfolio were to earn a total return of 8% per annum between now and retirement, $10,000 would grow to ~$80,000.
What is the independent retirement advice we offer?
- Don’t let short-term market action disturb your disciplined, long term retirement strategy.
- Volatility is uncomfortable, not dangerous and can be used to add to your portfolio at lower prices.
- Before you go down the path of premature distributions or taking out a loan, consider the real costs after taxes, penalties and damage to your long term retirement security.