How to Pick Funds for Your 401(k)

Paul Winkler: Welcome to The Investor Coaching Show, a podcast to help you get an insider’s view of the financial world and escape common investment traps. We look at the financial news of the day and help you make sense of it. So you can relax about money, and here’s your host, Paul Winkler.

Does Anyone Truly “Self-Invest?”

PW: Hey, welcome. This is The Investor Coaching Show. Paul Winkler, talking about the world of money and investing along with Mr. Jim Wood, who can also talk about money and investing. Matter of fact, he’s pretty good at it, and knows a few things here.

JW: A few things—one or two.

PW: I had a conversation this week with Michael, and we were talking about . . . he’s talking about do-it-yourself investing. And I said that people don’t ever do it themselves.

He said, “Well, what if they’re buying individual stocks?” I said, “Okay, if they’re buying individual stocks, that’s a whole different problem.” And yes, they do that themselves. But you know, typically when you’re buying mutual funds, there’s always a mutual fund company that’s actually doing the stock selection, managing the portfolio, making the decisions, and you just kind of think you’re making decisions, but you’re not really. And the reality of it is, that fund companies, you have to watch them very closely.

And then we got to talking about why pensions, you know, they have big pension managers and then what are they watching for? We got into this whole conversation about, you know, that the most successful investors are actually most educated and investors actually have somebody that’s watching the process every step of the way.

And then we got to talking about coaching and because this has been called The Investor Coaching Show for 20 years. And you know, the reason being, I believe that coaching is hugely important. And then we got to talking about Tiger Woods having been coached. And then he talked about how he had an auto accident. I said, “Well, I don’t know, pop culture.” I don’t need, I can’t even name another golfer. I probably could, but—

Jim Wood: Phil Mickelson.

PW: There you go. Thank you. And, and I’m just, I’m telling you, I just don’t follow much of anything in pop culture. And he goes, “Tom Brady.” And I said, “Okay, I know Tom Brady.”

JW: Do you know Tom Brady?

PW: Okay, so I know who he is. So he’s saying, “You know, does Tom Brady have a quarterback coach?” And, and uh, I said, “Well, yeah, of course, he’s got a quarterback coach.” And then I said, “Well, you know, think about this, Michael.” I said, “Why do we think money is less complicated than throwing a football?” And he goes, “That’s a really, really good point.” And I said, “You know, when you look at it. The level of complexity in managing money and the tax issues involved, choosing funds, you know, price to book, price to earnings ratios, looking at a standard deviation, looking at ratios as far as a return, you know, for every unit of risk taken. And you know, how do you analyze that? How do you analyze the way the portfolio is put together: price, market cap, and all of those different issues, turnover, ratios, and things like that. And this, it gets fairly complicated in a hurry, let alone the fact that Congress is changing the tax laws every single year.”

And you think, man, yeah. You know, it is kind of a daunting task. So for me, I tell people to ask questions, and it’s interesting because questions that people have quite often are on a much, much lower level as far as level of complexity, then, you know, typically what I think about. So I love questions. A lot of times people will ask things, and well, yeah. Okay. You know what? I really do need to cover that. So thank you, everybody that sends questions and anybody that sends questions into our show, thank you so much because it really helps me as far as coming up with content. Really super helpful.

JW: Let me add one quick comment on the do-it-yourselfers, and you see them, even somebody who’s buying those individual stocks and, yes, we’ve talked about problems with doing that and everything, but even them, you can kind of question, are they really doing it themselves? Cause where’s that information coming from? Are they buying a newsletter with stock recommendations? I mean, I doubt that or—

PW: They’ve heard about a company in the news and they buy it after their studies that show people do that. After something shows up in the news, that level of volume of that particular stock goes up . . .

JW: Significantly. Exactly. Few people are out there combing through the financials of these companies, or, certainly, you know, going out and interviewing the CEOs and stuff like that. So that can certainly skew your information and your choices and especially the phenomenal avalanche of stuff you get from the media and everything like that. So even then that whole do-it-yourself thing—

PW: Yeah. As people say, I’ve heard people say, “Do you choose stocks, or did the stocks choose you?” Yeah, it is. It’s a really, really good point. Yeah. Great point, Jim.

Is a Target Date Fund a Good Choice?

PW: So, you know, by the way, the questions, if you have something, Paulwinkler.com/question is the way you ask something. And what we do is, we’ll answer the question here on the show, and then send you a copy of that. So in case you happen to miss it, when we answer it live, you can actually do that. So Paulwinkler.com/question.

Lisa asked the question, “I have a new 401(k) plan I’m investing in, and would like to know if the funds I’ve chosen are good ones. How are the Fidelity funds,” First question, “and T. Rowe Price 2035. How is that?”

Okay, so number one, this is what’s called the target date fund, and target date funds are based on a certain year that you’re going to retire in 2035.

And the idea is that they actually change as you get older and get closer to the retirement date, adding bonds to the portfolio is what they’re going to be doing. And it’s interesting because if you actually look at various target date funds—there are a lot of them out there—2035 funds. You know, Fidelity’s got one. T. Rowe Price has one, Vanguard has one, John Hancock has one, a lot of different fund companies have them. And it’s interesting ’cause they’re all different from each other. If there were one great way of managing your money for retiring in 2035, you think they’d all be exactly the same.

JW: If you look at the glide path is what they’re called, how they change from stocks to bonds, to cash and those types of things. Everyone’s different. What I do find that they have in common is that they tend to get way too conservative too early. And they will do that I think in terms of not wanting to rock the boat. If there’s less volatility during market downturns, people are less likely to jump ship, but what that can—

PW: Retirement. Yeah. As you near retirement, people get really, really nervous, but keep going.

JW: But what that can also do is really compromise the long-term viability of the portfolio and keeping up with inflation. Yeah.

PW: I think that’s a really, really good point because when you look at studies in retirement, and there are a lot of really great studies on how to take income and how much income you can take. Having a lot more equities in the portfolio of stocks in the portfolio has historically been a far better way of being able to pull an income and outpace inflation. Because what’s inflation? Price is going up. Who’s raising prices? Companies. What do you own when you own stocks? You own the entities raising prices, as I always say.

So, yeah, it is a really, really good point that they do tend to get really, really conservative or too conservative for most investors. And you can’t, you know, there are some people, maybe it’s fine. But you know, in reality, for most people, if you’re needing to take the level of income to maximize the amount of income that you can take from a portfolio, typically they’re too conservative for that in one way.And then more aggressive in another way. The way they’re more aggressive quite often is that the level of diversification tends to be pretty bad.

Now let’s say we take the T. Rowe Price. The question is about that particular one there. No. I’m going to give, okay, what would I do instead? But I will always want to say why I’m answering the way I’m answering something. So if you look at the T. Rowe Price portfolio, if for a target date fund retiring in 2035, they’ve got a lot of different holdings. You look at it and say, “Wow, this is really well diversified.” They got the T. Rowe Price value Z fund, T. Rowe Price growth stocks, Z Equity Index 500, international value overseas stock, international stock, new income stock, mid-cap growth stock, emerging market stock, mid-cap values, a stock fund, small cap value stock fund, a small cap value Z fund, uh, new horizons, real assets.

They’ve got real assets fund. Whole problem there. I won’t even get into. But you got a lot of different funds. And, you know, even in the bond area, which I kind of skipped over most of them, but they got a high-yield bond fund, which I would look at and go, no, no, no, no, no high yield bonds. You’re lending money to companies that are in financial distress. And when the economy goes to heck in a handbasket, stocks go down and companies that are borrowing money that are in distress also have a struggle repaying that debt, and those bonds can go down as well.

So you got a couple of problems right there, but let’s just look at that and say, “Wow, there’s a lot of different funds.” But how diversified is it? If you look at Microsoft, four of those funds I named actually own Microsoft, the growth stock fund, large cap core fund, equity index fund, and the value fund own that. Amazon is owned by three of the funds. Samsung is owned by five of the mutual funds in there. Semiconductor is held by four. Alphabet, which is Google’s parent company, has five different mutual funds and owns that one stock. So I can go down and keep going through the list, but there’s a tremendous amount of overlap in the portfolios is one of the problems that you run into. And that’s not unusual with target date funds.

The Upside-Down Pyramid

JW: Yeah, well, so much so often when you look at the holdings of these funds, I like to think of it as the idea of the upside-down pyramid. Because if you line up all the stocks that they have, and even if they say, “Oh, we own hundreds of hundreds of things.” If you look at what they own, at the top of the pyramid are all the big names, the Amazon, the Apple, things like that. And then at the bottom, you just have a couple hundred companies just jammed down there in the tip that aren’t really represented. And there’s almost even no point in them being there because the portfolio is being dominated by those big names that everybody knows. And if it’s a time where those big names aren’t doing well, then that can really long term hurt your portfolio. You look at 2000, 2010. Big name US stocks went a whole decade without getting any return.

PW: Yeah. And I found when I was looking at people’s portfolios back then, you didn’t have, people were not holding the target date funds at all. And they were, “Now these funds stink. I know not to do that.” People would come in here and I thought, Oh, maybe they heard us talk about the issues with the fund companies choosing the investments for you. But what’s really funny is I’m actually seeing the opposite right now. And it really coincides with when big US growth companies do well. That’s when the target date funds become popular. When they’re not doing well, that’s when they lose their popularity. So it, again, it’s chasing return is what we find investors have a tendency to do.

JW: Target date funds. I always see them as having two purposes. One is to release some liability from employers because that way there’s a default option that’s approved by their regulators. That client, if people use that, then they won’t successfully sue the plan if they get bad returns. So that’s one reason. But I always think one of the biggest reasons is because then it makes an easy choice because you used to get this list of funds. And, you know, there’s a bunch of names like growth fund opportunity, this and that. And, no, you couldn’t make heads or tails of it, and people wouldn’t know what to do, but then they say, okay, now we have this easy “you pick based on your birthday.” And it gets people off the fence to where they can make a decision and move forward.

PW: Yeah, that’s it. That’s absolutely true. And you know what, your point earlier about the upside-down pyramid, you see that like for the target date funds, the T. Rowe Price funds, the large value stocks, 17% of the portfolio, 25% in core, another 21% growth, but only 4% in small, 7% in small blend, and then a 3% in small growth. So you’re very, very little holdings down in that area. It’s dominated by the big names in there, the big holdings.

Watch Out for Turnover Ratios

The other thing is this. One of the things that you may not realize, you may look at a target date fund, and you may have heard me talk about not buying funds and looking at watching for turnover ratio. So you don’t want them gambling with your money. Turnover ratio is how often do they change the stocks in the portfolio? And you might see a 100% turnover and go, “Oh my goodness. They change all the stocks in a calendar year.” And that’s what that turnover ratio means. But if you look at a target date fund, you may see a very low turnover ratio when you look at the fund and go, “Oh, okay, this meets Paul’s criteria for low turnover ratio.”

But, interestingly, when you look inside, it is a fund of mutual funds. It’s the way they work. Many of them, most of them, as matter of fact, work in that particular manner. Like T. Rowe Price is a fund of all those funds that I named. And if you actually look at the holdings like the emerging markets discovery stock fund, well, that fund actually had 81% turnover and you’ll have, you know, other funds, other mutual funds inside their 20%, 30%, 40%, 50% turnover on one fund was the large cap core fund had almost 68% turnover.

Their value fund had 114% turnover. So they’re changing stocks significantly inside that portfolio. And you go, well, why, and, and it’s actually, I looked up what’s called the average alpha in the funds, and it was significantly negative. In other words, the funds’ returns were lower negative versus what you would have expected based on the amount of risks that was actually taken. So that’s one thing. And then, you know, she brought up Fidelity as well, because I don’t want to leave them out. Same, same issue. If you look at their target date, 2035 fund, you’ll have, like, for example, Microsoft is held inside of that fund. It’s a fund of funds. It holds the series, large cap stock fund, blue chip growth fund, all sector equity fund, opportunistic insights fund growth company fund, emerging markets opportunity.

Amazon is held by four of the mutual funds inside that fund. Apple’s held by five of the funds inside of that fund. Facebook’s held by seven of the mutual funds inside of their . . . Alphabet, good grief. Eight or nine different mutual funds own that one stock inside the portfolio. So again, you have that issue with overlap, and it’s a lacking diversification problem that you run into with those mutual funds. And you got 18 different stock funds with a lot of stock funds, but the problem is you keep running into is lack of diversification. It’s just what I call perceived diversification. I perceive that I’m diversified, right?

JW: I mean, you know, if you have a fruit salad with 18 different types of apples, it’s not, you know, not—

PW: Really, I like that. That is well, that’s a good analogy. I mean, you look at that and go, “Wow. Yeah, that would be kind of boring to have all of that in there.” And, you know, an apple a day keeps the doctor away, but every fund owning the same thing may not be so good for your financial health. There we go then to tie that back in.

JW: You were talking about the turnover ratio and where that really comes into play, all that buying and selling of course is cost. Every time there’s a buyer and seller, there’s some friction. That means there is some cost to make that trade. And then that cost that manager has to overcome just to get back to market returns. And that’s why most managers, and certainly all of them as a group, never get back to market returns.

Prepare for Different Economic Terrains

PW: Yeah. So as far as it goes, yeah, the target, I’m not a big fan. Now, if we can, you know, to, to finish answering her question, what I try to do is select funds inside of what they give you access to and try to make up some of the . . . now I have been known to, not very often, but I have been known to take a target date fund and maybe hang on to it if it seems to be a fairly decent target date fund. As far as there’s not too much craziness going on and trading, and then supplement the missing asset classes. Like we talk about that small as missing. Well, I go, I don’t necessarily want smaller companies. They’re riskier. Well, what do we know from academic research? We know that when we add various areas of the market, like small companies, which are missing almost always from these target date funds, well pretty much always, I can’t think of an exception at this point where I haven’t seen that asset category has been missing in a target date fund.

So when I add that in there and I say, okay, so if I add some small companies in, or if I add more value in, which is typically severely lacking in target date funds. What happens is the overall risk comes down. Why? Because they don’t move together. I’m going to use an example I haven’t used in quite a while on the show, but I use this example in my book. Whereas diversification is how . . . and why does it work so well? Why do we use it? Why do we do it? And I use the example of investing being like a race. And, you know, I have a car that’s going to be in the race, a motorcycle. It’s going to be in the race. A dune buggy . . . and, you know, race car motorcycle, dune buggy, and a snowmobile. Now, those are four examples I use in the book and we don’t know what the terrain is going to be going forward.

I don’t know if it’s going to be. The course is a blind course. I don’t know what it’s going to be. There’s going to be a big veil in front of the track, and the race starts. And if it’s snow, well, the snowmobile takes that leg of the race. If the terrain happens to be sand, the dune buggy does really well and, and so on and so forth. Well, that’s investing. The economic terrain may be going forward that’s phenomenal for international small companies. And it’s just virtually a non-existent asset category in any of these funds. Small value? Forget it. You’re not going to find emerging market. You’re not going to find that either or emerging markets value. You’re typically not going to find a very good large value even, or international value choice inside these portfolios.

So if the economic terrain is really good for any of these asset categories I just named, you might as well forget these portfolios doing well. If the terrain is really good for large US stocks, anyway, those funds are going to actually do fairly well. So it’s not going to be a big difference between them. So that is one of the things that we do. We go, “I don’t know what’s going to happen going forward.” Nobody does. Now what we want to do is we want to augment the portfolios to add those asset categories that are missing. That’s one thing that might be done.

Another thing that might be done is if you have enough choices, and this is particularly true for those of you that actually have self-directed type programs out there. Now, I just got finished picking on that self-direction doesn’t actually exist, but you do have funds that are called self-directed, which is where you can go in and open up a brokerage account inside your 401k. And then we can go and select funds in most asset categories.

Typically not all asset categories that I’d want, but most, yeah, you’ve got a much, much broader group of investments that you can select from when you’re dealing with a brokerage account. You might have 9,000, 10,000 different funds out there. And then what you can do is, you can go, “Okay. Paul said, we gotta have an asset mix of 75% stocks, 25% bonds.” Okay. What kind of bonds? Oh, we’re going to be keeping safety at the forefront with our bonds so you can have short-term bonds and high- quality bonds. Okay. Now we got those chosen. Now we need large US stocks.

Well, not as much as target date funds app, but we do need some there. And then we need some small. Then we need some large value stocks. So how do we select that? Well, you go in, and one of the things that we do is we actually use a software program to help us determine what the price to book is. You know, price, earnings, ratios, how much turnover is going on inside of the portfolio. What’s the market cap of the funds. So it’s a very, very, you know, you’re going through a sophisticated process, but typically you can go and do that. If you have a self-directed, if you just have core funds, it’s going to be a little bit more difficult, but that’s typically what I do now. Here’s the beauty of it. I’m going to finish this segment with this.

Once you choose the investments, you know, once you’ve chosen the asset mix, how much are in large companies and small, and how much is in value versus growth, and international versus US, and how much you’re in the different types of bonds. The changes in the portfolio are very, very gradual. So once you have made those selections, and you’ve done the asset mix and done this properly, you don’t have to go and change it all the time based on what the market’s doing, what you think is going to happen next, because any changes that you make by definition are market timing or tactical asset allocation.

So what is critical is that once you go do this, don’t mess around with it. But letting the fund company do that, the problem with the fund company, these target date funds, just my experience, it’s constantly changing things, and that’s just another detriment to them. So I know that’s a pretty thorough answer, and I hope that that helps to some extent. Appreciate it.

If you’ve got questions, Paulwinkler.com/question. I want to tell you about a new Q&A feature I have for the show. There’s now a form on my website where you can submit questions for me to answer on the show. You can ask any question you want related to finance, money, and investing. You can even ask some fun, random questions too. Then we’ll review each question that comes in and choose some to answer. We’ll even let you know how to hear the answer to your question. Submit your questions by going to Paulwinkler.com/question. That’s Paulwinkler.com/question.

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