Today, we dive into the complexities of choosing funds in employer-sponsored retirement plans like 401(k)s and 403(b)s. Amy Walls from Thimbleberry Financial breaks down common misconceptions and essential strategies for fund selection. She clarifies that not all funds are created equal, debunking myths about choosing solely based on cost or past performance. Amy emphasizes the importance of aligning fund choices with individual investment objectives, risk tolerance, and the need for diversification across various asset classes.
Amy also tackles the topic of fees and performance, urging listeners to consider the value provided by a fund rather than just its expense ratio. A fund's net performance, after fees, is what truly matters. The conversation shifts to assessing fund performance, where Amy suggests using custodian-provided information and comparing it against benchmarks over various time frames. This approach helps in making informed decisions rather than chasing short-term gains.
The discussion addresses the risks associated with fund selection, including market volatility, inflation, interest rate changes, and the dangers of following unqualified advice from the internet. Amy advocates for a balanced approach to risk management through diversification and proper asset allocation. She also defends the use of target date funds, which can be a viable option for many investors, especially when other choices are limited or less appealing.
Finally, Amy advises on the frequency of reviewing and adjusting fund allocations, recommending at least an annual check-up to ensure alignment with one's financial goals and market conditions. This conversation underscores the importance of informed decision-making and seeking professional guidance when navigating the complexities of retirement fund selection.
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Jon Jag Gay: Welcome back to Thimbleberry U. I am Jon Jag Gay. Amy Walls from Thimbleberry Financial joins me as always. Welcome, Amy.
Amy Walls: Hey, Jag, good to talk to you.
Jag: Today we're talking about a topic that is universal to so many of our listeners and I say that because it strikes a chord with me personally and I just feel like I'm going to speak for all listeners here. We're talking about picking funds in 401(k) and 403(b)s, those employer-sponsored plans. Let me start with an easy question for you. What are some common misconceptions people have about choosing the funds in those plans?
Amy: Jag, I love that question. Misconceptions so often are more fun to talk about than what to really do.
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First thing I'd say is that all funds are created equal. Doesn't matter which one I pick, I could pick one, I can pick every one of them. They're all basically the same.
Jag: Really?
Amy: That's a misconception.
Jag: Oh, that's the misconception. You threw me there for a second. That is the misconception.
Amy: Yes. Another misconception is that I should always choose the least expensive option. It's always going to be best because I don't want to spend extra money. Number three, as a misconception again, I should always choose the best-performing option.
Jag: That's some we'll dive into for sure.
Amy: I'm going to say the fourth one that comes to mind is, again, misconception, I should always stay away from the target date funds that are available inside my plan.
Jag: I've heard that as a piece of advice, I'm glad you're clarifying that that's a misconception. We'll hit on that as well.
Amy: Absolutely.
Jag: All right. Let's get away from the misconceptions and more toward the shoulds. What are the main factors that people should consider when picking funds on their retirement plan?
Amy: The easy answer, which is probably a little too simple, is the opposite of what I just said.
Jag: Fair enough. That's the end of the podcast. Thanks, everybody.
Amy: Shortest podcast ever. First of all what are their investment objectives and risk tolerance? If you plan to be retiring - because these are retirement accounts, so I'm going to focus on retirement - in three years versus maybe you're starting out your career and you've got 30 years left, your objective for the money is different. Your risk tolerance may or may not be different. Other things that should be considered is what is your diversification look like now amongst your other assets?
What's the right mix of investments by type, not just tech stocks, for example, but what's the right mix of investments of large-cap and small-cap, and mid-cap, and bonds, and international emerging markets that you should have that's appropriate for your goals and time frames and risk? Other things that ties into our misconceptions, fees and expenses. They should be considered. Then also fund performance and track record, not just performance right now, but track record of performance is also important to consider.
Jag: That clarifies that first misconception. You should always choose the best-performing option because you're probably looking at a snapshot when you look at that. You also to your point here, want to look at the track record, not, what have you done for me lately.
Amy: If someone's looking just at, let's just look at the last six months, maybe someone sets in their calendar I'm going to change my funds review and change my funds every six months. They look and say, this has been the best-performing for the last six months, I should be in this because it's so much better than what I've been in. What goes up, comes down, and what goes down comes up. That person is likely to pretty consistently lag as things shift.
Jag: It's like chasing the market. With so many investment options available, Amy, this is a little overwhelming. How can investors effectively navigate their choices?
Amy: I mentioned reviewing investment objectives first, right?
Jag: Yes.
Amy: Knowing where you're at and what you need, that goes with that asset allocation. For example, if I'm that person three years away from retirement - and I'm speaking hypothetically, of course here - I likely am going to be needing that money when I retire or quit working if I'm just planning to be financially independent, and these dollars may be needed sooner. Then if I'm not going to stop working for 30 years, so let's assume that.
If I'm also going to be retiring in three years, maybe I've got more money out on the side. Maybe a lot of that is actually already conservative, in which case, to balance that out, maybe I do need these funds that I'm investing now to be aggressive in order to balance. Typically, we'd think that, hey, I might need to just be moderate across the board with these assets that I'm going to be using here in a couple of years. That means that I'm not going to have as much in stock as I would if I'm going to retire in 30 years.
Jag: Got it.
Amy: The ability to sleep at night plays into that too. Other things that can be looked at, I've mentioned the expenses on the funds sometimes, or I've mentioned that a couple of times. I think this is really important. Right now it's common if you're looking at the internet and things, you hear, oh, a fund with a high expense ratio is just a bad thing. Expense is bad in the absence of value. If there's value, expense is not bad. It's the opposite way of looking at--
Jag: A little bit of the, you get what you pay for sometimes.
Amy: Sometimes. There are definitely funds that are expensive and not terrific. They don't have a terrific current or past performance. There are others that might be expensive but have a really good, pretty consistent past performance and so it may be worth paying that expense. Let me give an example. I'm not going to use a real fund here in the podcast, but just a simple explanation that I think everybody can understand. If you have a fund that net of fees is paying 8% consistently, let's say over 20 years, and we think it's going to continue to do that, and you've got a fund that consistently is paying 6.5%, and they're the same kind of fund, both are net of expenses, do you care what the 8% fund, what its expenses really are?
Jag: When you say net of expenses, you mean that's the number after your expenses. After you factor in all these expenses, getting 8% versus getting 6.5%, at that point, who cares about the expenses?
Amy: It could be twice as expensive as the one paying 6.5% net of expenses. It just doesn't matter at that point. It might matter if performance falls off. That's something that I hear a lot of misconception around. I think also one of the things we touched on that there can be misconception around is understanding that when the return for any given period is quoted, the cost on a 401(k) or a 403(b) for that fund has already been removed.
Jag: Good to know.
Amy: Sometimes people try to subtract it off of the rate of return.
Jag: That's an important detail.
Amy: Been subtracted before reporting. Other ways is, I talked about investment objectives, there are online asset allocation tools that can give you an idea of how you might want to be allocated. That's a great thing to try if you don't know where to start. Then of course, seeking guidance. We help our clients with their current 401(k)s or 403(b)s at least annually.
Jag: This stuff can get really complicated. Asking a professional if you don't feel comfortable doing this yourself, the worst thing you can do is just throw caution to the wind and say, yes, this looks good. The next logical question then, Amy, is how do investors assess the performance of the funds in their 401(k)s or 403 (b)s?
Amy: The first thing is the custodian should be making this information available. We run into the question a lot about, where do I actually find it though? First place I'd look is a PDF of your 401(k) or 403(b) statement and look at all the pages. This isn't a screenshot off the website, but look at all the pages. Part of the time, especially at Fidelity, it is included in the last pages of the statement.
Jag: That's important.
Amy: Yes. If it's not, you can log in to your custodian and there will be somewhere where you can do research on the funds, and it will give past performance over different time frames. That's the first place, just the nuts and bolts of here's how to find it. Then looking through that, oftentimes it'll be broken down into large-cap funds or mid-cap funds, or small-cap, or international. It may be compared to a benchmark for that.
If my benchmark is, for the last year, 6%, and one of the funds has done 3% and one of them has done 8% over the last year, I'm probably going to lean more towards the 8%, but I'm not going to stop there. I'm going to look at both and say, how have they done consistently over different time frames? The 1-year, the 3-year, the 5-year, the 10-year compared to that benchmark. Because if I need, and let's just say this is a large cap fund and I've only got these two choices, which sometimes comes up, then I'm going to need to probably pick one of them for my asset allocation.
I'm going to need to choose. Maybe I do choose both of them and hedge my bets just depending on performance. You want to look across and try to compare to that benchmark to say, is one consistently outperforming the other if they're similar types of investments? One additional thing I should add, Jag, is that if you're comparing your performance compared to that benchmark or across a benchmark, be aware if you've made changes.
Jag: That's important.
Amy: If just six months ago you changed your whole portfolio and said, oh gosh, you listened to this podcast and said, I need to reallocate, and you went in and did that, and six months later you go to look at your performance, and you look over three years-
Jag: Apples and oranges.
Amy: -you're going to have a problem. Exactly.
Jag: Look, this stuff is hard. This stuff is tricky. What are some common risks associated with fund selection, and how can investors mitigate them when it comes to these employer sponsored plans?
Amy: You and I love to talk about risk and biases and such.
Jag: Oh, yes.
Amy: There's market risk. If markets go up or down, your portfolio is going to change. Inflation risk. Inflation impacts investments. Then interest rate risk. As interest rates go up, bond prices fall. If you are in bonds, and I'm not saying they're bad, because they're not, there's a spot for every investment, there's a reason it came about, well, then bond prices are likely to fall. Then I think there's a risk. I don't know if anyone's ever really dubbed it this way, so maybe I'm the first one to dub it this way, but I'm going to call it the Reddit risk.
Jag: I think I know where you're going here.
Amy: It's the risk that you take advice off of the internet and specifically off of a forum for like-minded people that may or may not know about the topic that's being discussed.
Jag: Because on the internet, everybody's an expert.
Amy: Absolutely.
Jag: It's like, heck, I've got a cut on my finger. By the time I'm done googling it, I'm dying. The same risk runs from looking for financial advice on the internet as it does for medical advice.
Amy: Yes. Game stop.
Jag: [laughs] That's exactly what I was thinking.
Amy: There are strategies for risk mitigation, and there are things we've already talked about. Diversifying and asset allocation. Diversifying and asset allocation aren't exactly the same. Asset allocation is taking all these different asset classes of investments and figuring out the appropriate mix you should have in each one. Let's say that you need 25% in large company growth stocks. According to the asset allocation you figure out. Now, you can take that 25% and you can put it in a variety of large-cap growth stocks or you could just put 25% in Apple. Buying a variety is what gives you diversification. If you bought one stock in each of the asset classes, you would not be diversified.
Jag: Amy, one of the myths you threw out off the top was staying away from target date funds. Those set it and forget it based on what year you plan on retiring. Why do you feel that's a myth?
Amy: Because frequently after reviewing the investment choices within our clients' 401(k)s or 403(b)s, they don't have good options and their target date funds are actually the best option.
Jag: Really?
Amy: Yes. Some of the target date funds are absolutely incredible and not high cost. When someone has, just like we just talked about diversification, that if you need large-cap growth and you only have one option and it's not a terrific option, and that applies around all the different asset classes where you just don't have much selection, a target date fund, especially if it's one of the good ones, and I'm not going to throw names out here, can be a great option.
The other thing is, when I talk about a good target date fund, we evaluate any fund and any portfolio for risk and return. Sometimes, even when there are a few options in the 401(k), we're not just limited to six total funds outside of target date funds, the risk and return of any portfolio we can build from what's available just isn't great compared to those target date funds. They are not bad. Sometimes people think they're cheating by doing that.
Jag: Set it and forget it.
Amy: Here's the reality. Off the top of my head, I can't name the study that was done around this, but studies have shown that since target date funds rolled out in 401(k)s, performance overall in 401(k)s has gone up as a result of them being used. This goes a little bit, I think the idea, the psychology behind it has to do with biases, that if I'm watching this and making the choices, I know what's going on and I can pick better. In a target date fund, there's almost a shield of invisibility. There's a curtain. It's like the man behind the curtain. You can't second-guess that diversification and the rebalancing, the reallocating that's happening inside the fund, which means that people are safer and getting better performance. At least that's what the study is showing.
Jag: Before we wrap up, Amy, and that was helpful, thank you, how often should investors review and adjust those allocations?
Amy: Great question, Jag. Rebalancing at least annually, maybe more frequently. Some of these plans, some of the custodians will give an option to rebalance every quarter or every six months. I think quarterly is a terrific time to rebalance, if the option's available. Weekly or monthly is probably a little bit of overkill, but at least annually if you have to go in and do it manually. Reallocating, we look at our clients' 401(k)s or 403(b)s annually when we're doing their planning to say, is it time to mix this up? We will also look at it if new fund choices come out for that employer, or the plan moves from one custodian to another, they're going to get new fund choices. Annually, I think is appropriate there.
Jag: Again, I don't want to be selfish here, Amy, but you've given me a lot of clarity on this stuff because I was always confused by it, and I'm sure the same is true for many of our listeners. Again, the key takeaway here is if you need help, ask. If one of our listeners has questions about this or just wants to talk to you about their financial future in general, how do they best find you and your team at Thimbleberry Financial?
Amy: They can reach us online at thimbleberryfinancial.com, or by giving us a call at 503-610-6510.
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Jag: Great stuff. As always, Amy, we'll talk again soon.
Amy: Sounds good, Jag.
Jag: Security is offered through registered representatives of Cambridge Investment Research Inc, a broker-dealer member of FINRA SIPC. Advisory service is through Cambridge Investment Research Advisors Inc, a registered investment advisor. Cambridge and Thimbleberry Financial are not affiliated. Discussions in this show should not be construed as specific recommendations or investment advice.
Always consult with your investment professional before making important investment decisions. Security is offered through registered representatives of Cambridge Investment Research Inc, a broker-dealer member of FINRA SIPC. Advisory service is through Cambridge Investment Research Advisors Inc, a registered investment advisor. Cambridge and Thimbleberry Financial are not affiliated.
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