The Voodoo That We Do

By Scott Lummer
Chief Investment Officer, mPower

This week I will respond to two questions. The first comes from one of our clients -- he is an employee of a company that has hired mPower to deliver advice to participants on their 401(k) investments. (mPower also publishes this web site.) My answer offers insight into how an investment advisor selects funds.

The second question is a doozy, so be sure to stick around to read it.

Here's question one. In the interest of not naming names, I took some poetic license.

Dear Scott:
In addition to an international fund, a bond fund, and two other domestic funds, your company's recommendation suggests I put 24% of my money in "The Really Boring Mutual Fund" (RBM) and nothing in the "Sexy and Exciting Value Fund" (SEV). However, SEV has outperformed RBM by an average of 7% per year over the past five years. Why do you ignore this performance in making your recommendation?

There are two general tenets we follow that are relevant to your question. The first is that we do not merely chase past high returns. Simply buying the fund that performed best in the past may look good on paper, but it typically leads to disastrous results. This is because funds that have provided very high returns usually take high risks as well. And sometimes, those risks don't pay off. Also, simply picking funds that performed well in the past leads to a group of funds that is not diversified. These funds performed well at the same time because of a factor related to them all, and if that factor no longer holds, their performance may suffer en masse. Our company's analysts do take past performance into account, but we also analyze the reasons for the performance and research the potential risks of the fund.

The second tenet is broad diversification. We don't want our clients overexposed to any one sector of the market. This means we look at each fund not only in isolation but also in combination with the other funds in the client's portfolio.

For your allocation, we have two other domestic equity funds -- the broad-based "Quantitative Index Fund" (QI) which provides predictability and stability, and the "Very Highly Priced Stock Fund" (VHPS) which invests in a mix of large and small companies with high growth opportunities. In determining which fund, RBM or SEV, is a better addition, we would consider several factors:

• RBM invests primarily in value-oriented stocks (stocks that have a lower price-to-earnings ratio). SEV used to be a value-oriented fund, but over the past few years it has switched its style to mainly growth stocks (such as Dell, Gateway, AOL, and Nextel). While these are fine companies, their stock prices will clearly be high, which encompasses a greater degree of risk. More importantly, this fund's new investment style exposes it to many of the same risks that the VHPS fund has. Hence, RBM relates better with the other funds in your portfolio.
• RBM fund offers broad diversification across industries. No more than 20% of fund holdings are concentrated in any one industry sector. Over 60% of SEV's holdings are in two sectors -- financials and technology. This adds to the fund's risk.
• RBM has broader security diversification. No individual stock comprises more than 3% of RBM's holdings. Meanwhile, SEV has invested over 14% in AOL.
• Over the past year, SEV has displayed some of the potential risk discussed above. During the second and third quarters, the market showed some weakness, earning slightly over a 2.5% return. SEV lost over 4% during the same period, due to the volatility of higher-risk investments in its portfolio.

None of this is to suggest that SEV is a bad fund. However, to accomplish your goals you're willing to accept a relatively high level of risk, and for that risk level we recommend a combination of RBM with your other funds.

Our objective is to create a fund allocation that works well in a variety of economic environments, not just that of the past 5 or 10 years. Of course, the market may continue to show impressive returns in the future, and Internet stocks may continue to blossom. If that occurs, your portfolio will thrive as well (although perhaps not as much as SEV). However, should we see a large market correction, or a settling of values of Internet and technology stocks, investors would regret overexposure to risky growth-oriented stocks. Our job is to try to prevent such regret.

And now, the second question.

Dear Scott:
I have $53,000 in my 401(k) right now. I will be 59 years old in 2010. I want to realize a 30% return annually until then. Is this unreasonable to expect?

Come close because I want to whisper the answer to you.
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YES, IT IS UNREASONABLE TO EXPECT A 30% RETURN ON YOUR INVESTMENT!!!!

Sorry, I had to get that out of my system. But one aspect about investing that most concerns me right now is the unrealistic expectations some people have for their investments' future returns. There has never been a 10-year period during which stocks have earned even close to 30%. The largest ever 10-year return was 19%, and a much more typical average is 11%. You planning for retirement based on an assumption of a 30% annual return is like me making dinner reservations for a date with Michelle Pfeiffer. It may be fun to fantasize about, but it's not going to happen.

There is one key difference between our two fantasies, however. My unrealistic fantasy is harmless. But the fantasy of expecting 30% returns will lead to drastic under-investing, and instead of dining with "Catwoman" you will be dining on cat food. Do not expect a return of much more than the historical average when planning for your retirement.

Now, Michelle, if you are reading this, I was only kidding about the dinner being an unrealistic fantasy.

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.

The Voodoo That We Do

By Scott Lummer
Chief Investment Officer, mPower

This week I will respond to two questions. The first comes from one of our clients -- he is an employee of a company that has hired mPower to deliver advice to participants on their 401(k) investments. (mPower also publishes this web site.) My answer offers insight into how an investment advisor selects funds.

The second question is a doozy, so be sure to stick around to read it.

Here's question one. In the interest of not naming names, I took some poetic license.

Dear Scott:
In addition to an international fund, a bond fund, and two other domestic funds, your company's recommendation suggests I put 24% of my money in "The Really Boring Mutual Fund" (RBM) and nothing in the "Sexy and Exciting Value Fund" (SEV). However, SEV has outperformed RBM by an average of 7% per year over the past five years. Why do you ignore this performance in making your recommendation?

There are two general tenets we follow that are relevant to your question. The first is that we do not merely chase past high returns. Simply buying the fund that performed best in the past may look good on paper, but it typically leads to disastrous results. This is because funds that have provided very high returns usually take high risks as well. And sometimes, those risks don't pay off. Also, simply picking funds that performed well in the past leads to a group of funds that is not diversified. These funds performed well at the same time because of a factor related to them all, and if that factor no longer holds, their performance may suffer en masse. Our company's analysts do take past performance into account, but we also analyze the reasons for the performance and research the potential risks of the fund.

The second tenet is broad diversification. We don't want our clients overexposed to any one sector of the market. This means we look at each fund not only in isolation but also in combination with the other funds in the client's portfolio.

For your allocation, we have two other domestic equity funds -- the broad-based "Quantitative Index Fund" (QI) which provides predictability and stability, and the "Very Highly Priced Stock Fund" (VHPS) which invests in a mix of large and small companies with high growth opportunities. In determining which fund, RBM or SEV, is a better addition, we would consider several factors:

• RBM invests primarily in value-oriented stocks (stocks that have a lower price-to-earnings ratio). SEV used to be a value-oriented fund, but over the past few years it has switched its style to mainly growth stocks (such as Dell, Gateway, AOL, and Nextel). While these are fine companies, their stock prices will clearly be high, which encompasses a greater degree of risk. More importantly, this fund's new investment style exposes it to many of the same risks that the VHPS fund has. Hence, RBM relates better with the other funds in your portfolio.
• RBM fund offers broad diversification across industries. No more than 20% of fund holdings are concentrated in any one industry sector. Over 60% of SEV's holdings are in two sectors -- financials and technology. This adds to the fund's risk.
• RBM has broader security diversification. No individual stock comprises more than 3% of RBM's holdings. Meanwhile, SEV has invested over 14% in AOL.
• Over the past year, SEV has displayed some of the potential risk discussed above. During the second and third quarters, the market showed some weakness, earning slightly over a 2.5% return. SEV lost over 4% during the same period, due to the volatility of higher-risk investments in its portfolio.

None of this is to suggest that SEV is a bad fund. However, to accomplish your goals you're willing to accept a relatively high level of risk, and for that risk level we recommend a combination of RBM with your other funds.

Our objective is to create a fund allocation that works well in a variety of economic environments, not just that of the past 5 or 10 years. Of course, the market may continue to show impressive returns in the future, and Internet stocks may continue to blossom. If that occurs, your portfolio will thrive as well (although perhaps not as much as SEV). However, should we see a large market correction, or a settling of values of Internet and technology stocks, investors would regret overexposure to risky growth-oriented stocks. Our job is to try to prevent such regret.

And now, the second question.

Dear Scott:
I have $53,000 in my 401(k) right now. I will be 59 years old in 2010. I want to realize a 30% return annually until then. Is this unreasonable to expect?

Come close because I want to whisper the answer to you.
Scroll down for the answer:
.
.
.
.
.
.
.
.
.
.
.
. Continue scrolling...
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
. Keep going...
.
.
.
.
.
.
.
.
.
YES, IT IS UNREASONABLE TO EXPECT A 30% RETURN ON YOUR INVESTMENT!!!!

Sorry, I had to get that out of my system. But one aspect about investing that most concerns me right now is the unrealistic expectations some people have for their investments' future returns. There has never been a 10-year period during which stocks have earned even close to 30%. The largest ever 10-year return was 19%, and a much more typical average is 11%. You planning for retirement based on an assumption of a 30% annual return is like me making dinner reservations for a date with Michelle Pfeiffer. It may be fun to fantasize about, but it's not going to happen.

There is one key difference between our two fantasies, however. My unrealistic fantasy is harmless. But the fantasy of expecting 30% returns will lead to drastic under-investing, and instead of dining with "Catwoman" you will be dining on cat food. Do not expect a return of much more than the historical average when planning for your retirement.

Now, Michelle, if you are reading this, I was only kidding about the dinner being an unrealistic fantasy.

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.