The Myth of the Dumb 401(k) Investor

Fools, Damned Fools, and 401(k) Shareholders
Saturday morning's Yahoo greeted me with the headline, "401(k) investors are 'so dumb' says Pro." That puzzled me. As dummies go, 401(k) investors don't seem to rate. For the most part, they put their money--or are defaulted--into large, mainstream, diversified funds that perform pretty much like market benchmarks. It would seem to be a dull tale.

From the article (which was taken from a CNBC interview):

Ric Edelman of Edelman Financial Services was referencing new research from Aon Hewitt that showed individual investors, spooked by the sharp and sudden market swings, have started to change allocations in their portfolios, going out of stocks and into bonds.

For example, the research says, "On Tuesday, October 14, a day after the S&P 500 was off 1.65 percent, 88% of trades saw money flowing to fixed income."

"When retail investors do that, all they're doing is selling low. Think about it. They're waiting until the market drops to take money out of stocks. That's completely backward."

That is, in Edelman's words, "dumb."

I did not know that Aon Hewitt published daily 401(k) trading statistics. Cool. Here is the most recent data.

I'll skip the details; if you wish to see them, here is the original chart in a larger size. The key points are:

1) As Edelman states, 401(k) transfer activity appears to be inversely related to the previous day's stock-market results. If stocks rose, then the next day the Aon Hewitt 401(k) Index tends to show that investors shifted toward equities. If stocks fell, the reverse.

2) The effect, however, is small. The red, yellow, and blue bars represent daily trading volume, that is transfer dollars/total dollars. The scale ranges from 0.02% for the shortest blue bars to 0.06% for the two red bars. Thus, even on the heavy trading days, more than 99.9% of 401(k) assets stay put.

The figures shrink further when assessing net movements. The red line on the bottom chart shows the percentage of trades into equities. As it turns out, that number is close to 50% on the days of the two red bars, meaning that just as much money went into stocks from 401(k) investors as went out. In aggregate, nothing much happened. 

The total also appears more muted when measured by the month. Yes, there were four days out of five in mid-October when 401(k) investors were mostly selling equities--but there were three straight days after that, and a couple earlier in the month, where they were heavy buyers. From the perspective of a mutual fund manager, then, the sales were pretty much noise. Meet a few redemptions one day, receive some cash another day … by month's end, the activity mostly balances out.

3) The largest net movement in October was indeed on the 14th, as Edelman identifies. On that day, about 0.04% of 401(k) monies moved out of stocks and into fixed-income securities. Assuming that the Aon Hewitt trading pattern holds true for the entire defined-contribution industry, which contains $4.5 trillion in assets, $18 billion of 401(k) assets rolled out of stocks on the 14th. For comparison's sake, total dollar trading volume on Nasdaq and NYSE for that day was $124 billion.

By those numbers, 401(k) activity was a significant if not majority factor. Again, though, those transfers occurred primarily with funds, not directly held stocks, and were therefore handled primarily with a fund's residual cash, rather than through equity sales. In short, 401(k) activity was a side note to the stock market's trading volume. Whatever the source of October's volatility, it did not come from the moves of 401(k) investors.

4) Aon Hewitt shades a trading bar red if the day's volume is more than double the average. That only two bars are red in the year's messiest month indicates that 401(k) investors, by and large, are difficult to rouse. They tend to be among the last to respond to heightened volatility, not the first.

Portraying 401(k) investors as the market's bottom feeders is nothing new. Fifteen years ago, the meme was how ignorant 401(k) owners had become accustomed to the grand bull market and would flee en masse when the stock bear market finally arrived. The bear did arrive, of course, in 2000, and sure enough 401(k) shareholders did behave differently. They were less active than were other stock holders. Sometimes ignorance can indeed be bliss.

The accusation that 401(k) investors make bad investment decisions was wrong then, it is wrong now, and it will surely be wrong when leveled 15 years from now.

That 401(k) investors fare relatively well with their asset allocations and trading strategies is, sadly, not this tale's final chapter. Many workers lack access to defined-contribution plans, have access but are too poor to make significant contributions, or have the ability to contribute but choose otherwise. Many also cash out of their plans when leaving jobs, particularly when they are young. These are genuine problems that remain largely unaddressed. 

Those items are outside of the purview of financial advisors--meaning that they receive less public attention, and less commentary, than do the relatively minor issues of imperfect investment decisions. However, the big problems are not readily resolved. Achieving universal, meaningful enrollment in defined-contribution plans, so that the second leg of the three-legged retirement stool is firmly constructed, would seem to require changes in public policy. The odds of that occurring anytime soon appear to be low indeed. 

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.