Barron's Online – 3 Ways Investors Ruin Their Nesteggs

by Karen Hube
Monday, March 17, 2008

These are scary times for investors trying to shore up their retirement
portfolios. Stocks’ values are down, inflation is ticking up and home prices
are sliding. But as investors nervously eye all that, they may be overlooking
the biggest threat of all: themselves.

“How you react to negative news about the markets can do far more
damage to your retirement portfolio than temporary trends in the market,”
says Mark Cortazzo, an investment adviser at Macro Consulting Group in
Parsippany, N.J. “Investors can truly be their own worst enemies.”

While investors are prone to making mistakes no matter which direction the
market is headed, when stocks lose value — as they have for four consecutive
months — investor errors can have more exaggerated effects on wealth, Cortazzo
says.

So how much damage does the average investor inflict upon himself in real
numbers?

At the request of Barron’s, Christopher Cordaro, an investment
adviser in Chatham, N.J., with Regent Atlantic Capital, ran some
calculations to answer this question, and the answer isn’t pretty.

Bottom line: Simply by making three of the most common errors — failing to
diversify wisely, trying to time the market and overpaying on investment
expenses — you would have missed out on $375,000 of gains on a $1 million
portfolio invested for the 10 years through January 2008.

Cordaro found that a wisely constructed portfolio free of investor error
would have returned an average annual 6.86% during that period and grown to
about $1,942,000. But factor in the three errors, and the return shrinks to
4.59%, while the ending account balance drops to about $1,567,000. In general,
the smart portfolio was broadly diversified in terms of both asset class and country. It made no attempts to call tops and bottoms in the market, and it
steered clear of pointless but all-too-common fees.

The worst part, Cordaro says, is that investors often don’t even realize
they’re sabotaging their nest eggs — because the slippage in return isn’t
sudden or drastic. “It’s small enough that they don’t notice it, but it is
slowly eating away at their financial independence like a cancer,” he
says.

The good news? If you know what to look for, chances are you’ll be able to
avert disaster. Here is a rundown on the three most common and costliest
mistakes that investors make with their nest eggs.

Neglecting Asset Allocation

Practically all investors would agree that they want the best returns and
the lowest possible risk. But when it comes to setting up a portfolio to
deliver on that promise, many investors don’t go the distance — and they pay
dearly for it.

The best way for an average investor to achieve the highest risk-adjusted
rewards is to allocate investments broadly across different asset classes. Yet
few investors do so: According to a 2007 survey of 401(k) assets by the Profit
Sharing and 401(k) Council of America, the average investor holds
some 25% of 401(k) assets in his own company stock. Beyond that, at least a
third of assets are in domestic stocks. Less than 8% of retirement-plan assets
are in non-U.S. stocks, and fewer than 1% are in real estate.

In Cordaro’s example, you can see how an investor can buff up a return by
refining his asset allocation. A simple allocation of 60% in large U.S. growth and
value stocks and 40% in intermediate bonds would have delivered a 5.2% average
annual return in the 10-year period ending January 2008. Add a sprinkling of
small U.S.
growth and value stocks, and large foreign stocks, and you boost your return to
5.7%. Better yet, add some world bonds, emerging markets and real estate, and
the return plumps up to 6.4%.

That latter portfolio, Cordaro says, was invested 30% in large U.S. growth
and value stocks, 10% in small U.S. growth and value stocks, 10% in large
foreign growth and value stocks, 5% in emerging markets, 35% in intermediate
bonds, 5% in world bonds and 5% in real estate.

Juggling a number of asset classes isn’t always easy. Jay Berger, a partner
at Independent Wealth Management in Traverse City, Mich., said that in 2006,
clients panicked over the Pimco Commodity Real Return Fund’s 3% decline.
“We explained that we need a portfolio with assets moving in different
directions. The best analogy is: Look at it as a perennial garden. If
everything is in bloom at the same time, that probably means everything will
wilt at the same time.”

Timing the Market

Investors have such a dismal record of being able to time the market that
mutual-fund inflows and outflows appear to be contrary indicators of which way
the market is heading, says Meir Statman, a finance professor at Santa Clara University in California.

“It’s not the perfect-idiot forecast,” he says, but it’s close.
Ideally, of course, you would want to sell your holdings when prices are high
and poised to drop, and buy stocks on sale, right before a run-up in values.

But over the past decade, investors have done the exact opposite. The month
with the biggest-ever net inflows of assets into stock mutual funds occurred in
February of 2000, “which was the doorstep of one of the worst declines in
history,” says Ernie Ankrim, chief investment strategist at Russell Investments. The biggest outflows were also poorly timed: Some of
the biggest occurred in the months leading up to October 2002, when the market
hit bottom.

“This kind of behavior of getting excited after good news and scared
after bad news causes investors to give up between 2.5 and three percentage
points a year,” Ankrim says. “The whole reason investors put up with
the volatility of stocks is to gain about three or four percentage points over
bonds — if we give most of that back, that means we’re accepting all of the
volatility of the stock market for no good reason.”

In the 10-year period of Cordaro’s example, investors suffered more modestly
than Ankrim’s estimates, but losses were still significant. Using actual
mutual-fund flows over 10 years ending January 2008, Cordaro found that market
timing cost the average investor a half percentage point of
return each year. On his $1 million portfolio, that means missing out on
$93,000 in gains.

You don’t need to be near a long-term market top or bottom to do serious
damage. From 1980 through 2006, investors who missed out on just the five
best-performing days in the Standard & Poor’s 500
index would have ended up with 26% less than someone fully
invested in the index during that period, says Carolyn Clancy, executive vice
president of Personal Investments, a division of Fidelity Investments.
“Missing just 30 of the best-performing days would have reduced the value
by 73%,” she adds.

Another kind of market timing is more passive, yet still destructive: It is
simply to stop feeding more money into your investments in rockier times.

Consider this: According to a 2007 study by Dalbar’s, a mutual-fund research
firm, if you had invested $10,000 in the S&P 500 index over 20 years
through December 2006 in a sporadic pattern that matches actual behavior of mutual-fund
investors during that period, you would have ended up with a
total of $33,252.

If, however, you had systematically invested the $10,000 in equal increments
over 20 years — through good times and bad-you would have ended up with
$42,877. The study found that even if you chose a fund that captured only 75%
of the S&P 500‘s return, by dollar-cost averaging you would still end up with more than if you had sporadically invested in the
S&P 500 fund.

Paying Too Much

Before you win cocktail-bragging rights for earning a robust return on an
investment, be sure to factor in how much you paid for your winnings through
expenses and fees.

While more investors than ever before are seeking out low-cost mutual funds,
there are still investors who believe that they need to pay higher expenses for
better performance, says Mercer Bullard, a securities-law professor at the University of Mississippi.
But, he adds, there is no evidence to support that. Higher fees simply do not
indicate better management.

Consider S&P 500 index funds. While the performance
of these funds is practically identical, given that they mirror the same index,
expenses are all over the map — some funds charge no load, some have no load
but do have a so-called 12b-1 fee, which is an operating expense, and
yet others have both a load and a 12b-1 fee.

A 2006 study by Zero Alpha Group, a network of advisory firms, and Fund
Democracy, a shareholder-advocacy group, looked at how much investors would pay
in fees if they invested $10,000 in these funds for 20 years and earned an
average annual 10% gain. It found that the average investor would have paid $2,582
in fees in the lowest-cost fund; $3,744 in the fund with only a 12b-1 fee, and
$7,600 in the load fund with the 12b-1 fee.

In Cordaro’s hypothetical $1 million portfolio invested 10 years ago, he
looked at the impact that half a percentage point in fees can make on a
portfolio. While his best-case portfolio earned an average annual return of
6.86%, he found that if higher fees knocked half a percentage point off of
returns, an investor would have ended up with $1,848,865 rather than
$1,941,837.

Taken altogether, Cordaro says, the impact of investor error — even
seemingly small ones — can be grievous over the long term. “We’re talking
about the difference in being able to retire in comfort or having to work many
more years to meet your goals.”