Beware this ‘dangerous blessing’ for 401(k)s

Last year’s stock market blowout is apt to prove “a dangerous blessing” for many ordinary retirement plan savers, Liberum chief market strategist Joachim Klement warns.

Thanks to the boom in the S&P 500 SPX, -1.84% and the fall in the bond market TMUBMUSD10Y, 1.876%, many are now taking on far more risk in their portfolio than they intended, can handle, or may even realize, he warns.

Read: Market Snapshot: U.S. stock futures slump as 10-year yield tops 1.80%

Making matters more dangerous still is that many will respond to the situation not by scaling back on the risk in their portfolios but by ramping it up still further, he adds.

“Stock markets in the United States, the U.K., and Europe were up more than 20% in 2021, private equity was up more than 70% (at least in the listed space) and real estate was up more than 20% globally as well,” London-based Klement points out. “As long as you didn’t invest in emerging market equities, gold, or nominal government bonds, all of which had negative returns in 2021, it was very hard not to make money last year.”

But “a year like 2021 is a dangerous blessing,” he says. “Behavioural finance research of the last 40 years has taught us that investors, no matter how sophisticated they are, see their risk preferences drift in reaction to past experiences.”

This may be an especially dangerous time for that to happen. Cautious Minneapolis-based fund company Leuthold calculates in its latest monthly report that U.S. stock valuations are now so far above any previous measure that “If there’s merely a reversion to the typical “New Era” bull market peak,” meaning a previous peak since 1995 — “the average stock would drop 29%” The typical S&P 500 stock, they add, is now far more expensive in relation to sales, earnings and other fundamentals than even in March 2000 or October 2007.

Meanwhile, do the math on portfolios. Last year the S&P 500 SPY, -1.77% returned 28.5%, while the U.S. bond index AGG, -0.61% earned minus 4.4%. So even if you do nothing whatsoever, if your portfolio a year ago was a typical 60% U.S. stocks and 40% U.S. bonds it’s now about 67% U.S. stocks and only 33% bonds.

Or, to put it another way, you are no longer holding $1.50 in risky stocks for every $1 in bonds, but $2 in stocks.

This is the moment when we remember that the S&P 500 fell by about half during the bear market of 2000-2 and again in 2007-9. In a few weeks in March of 2020 it fell by a third.

This is why financial experts recommend regular rebalancing: Selling some of whatever did best, and buying some of what did badly, to restore the original balance of risk in the portfolio.

This rebalancing goes against human psychology. As Klement points out, investors typically either do nothing, or — even worse — go the other way, and ramp up their risk even more at the wrong times.

Managers of the successful Davis mutual funds point out that over the past 20 years, for example, the average investor in a U.S. stock mutual fund has ended up doing much worse than their funds. Investors have tended to add money only after the market (and the fund) have gone up, and then take some out again only after it has fallen. Davis, citing data compiled by financial analysts at Dalbar, Inc., say the performance gap has averaged nearly a full percentage point a year.

Or, put another way, the average investor has missed out over the past 20 years on nearly one fifth of the stock market gains they would have pocketed if they had just held on.

Rebalancing between stocks and bonds is not intended to time the market, but simply to keep portfolios at a reasonably constant level of risk. The times when it feels hardest to do are probably the times when it is most important.

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