2014 has been something of a lackluster year in the markets. Economic data and earnings results haven’t exactly lived up to the expectations implied by last year’s 30% returns. With earnings season almost over, about 76% of the companies in the S&P 500 have beaten analyst estimates. But keep in mind, those estimates were not particularly high to begin with; Bloomberg expects S&P 500 revenues and profits to rise by 4.0% and 7.2%, respectively, in 2014.
Meanwhile, GDP growth in the first quarter was barely above zero, and the labor force participation rate continues to drift into generational lows.
The S&P 500 is flat for the year, and we’re now entering the months that have historically shown the weakest returns. Using S&P 500 data for the January 1950 to March 2014 period, average monthly returns for the May to October months is just 0.23% compared to 1.16% for the November to April months.
With all of this in mind, what should American investors do with their 401k plans? For most middle class Americans, the 401k plan is the bedrock of their retirement nest egg, and for many the mutual funds in the 401k plan are the only stock market investments they own. (Data from the Fed shows that only 15% of Americans own stocks outside of a mutual fund or retirement plan, whereas more than 35% of Americans have a 401k plan or equivalent.)
The lifestyle you enjoy in retirement will depend largely on the returns you generate in your 401k plan, which in turn depends on your ability to manage risk and avoid major drawdowns. Today, we’re going to do exactly that—we’re going to look for ways to boost returns while also lowering portfolio risk.
Increase International Exposure
I’ll start with an uncomfortable truth: U.S. stocks, as a whole, are overvalued and priced to deliver sub-par returns going forward. The S&P 500 trades for nearly 19 times earnings. To put that in perspective, the average over its history has been 15.5, meaning that U.S. stocks are more than 20% more expensive than average.
The cyclically-adjusted P/E ratio, or “CAPE,” which uses a 10-year rolling average of earnings to smooth out the fluctuations of the economic cycle, also points to an expensive market. At 25.6, the CAPE has only been this expensive a handful of times in history.
Yet overseas, we see a very different picture. CAPE ratios in much of Europe and in emerging markets are at or below their long-term averages.
Most 401k plans have at least a couple options for “international” or “global” funds. Consider upping your allocation to non-U.S. stocks to 50% or more of the portion of your portfolio allocated to stocks.
Buy low and sell high. This is the fundamental rule of investing, yet it can be remarkably hard to put into practice in the real world of portfolio management. As investors, it seems we are hardwired to chase performance and allocate to sectors only after they’ve already seen their greatest moves.
The best way to systematically buy low and sell high is to systematically rebalance. Of course, if you are young and your 401k account balance is relatively low, you effectively rebalance every pay period when you add additional funds. But if you’ve been investing for a while and your account balance is well into six or seven figures, those regular paycheck contributions make up an increasingly smaller piece of the pie. Rebalancing becomes increasingly important the larger your account balance becomes.
How does this work in practice? The asset classes at your disposal will vary from plan to plan, but most will offer, at a minimum, a selection of large cap, small cap and mid cap funds. If you’re lucky, your plan might also offer REITs, MLPs, foreign stocks, dividend-focused funds or other, more exotic asset classes.
Build an asset allocation that, while heavy in high-quality large caps, also gives exposure to these other asset classes. Historically, foreign stocks, REITs, MLPs and small and mid-cap stocks have all offered competitive returns, but they don’t necessarily track each other in any given year. Once a year, sell down the asset classes that have outperformed and reallocate to those that have lagged. In 2014, for most investors this would mean reducing your exposure to U.S. large caps and reallocating primarily to foreign stocks and REITs.
You’ll notice I conspicuously left bonds out of the discussion. There is a reason for this. Bonds have lower expected returns than the other asset classes discussed, and this is particularly true given their low yields today. Consistently reallocating to bonds given current yields may reduce portfolio risk, but it will do so at the expense of also reducing expected returns. So, the rebalancing I’m talking about here should be understood as rebalancing among growth asset classes with comparable expected returns.
Time Your Contributions
This final suggestion will be a little controversial, but hear me out. To the extent your plan will allow, try to increase your contributions in the fall and winter in order to take advantage of the better returns historically enjoyed from the October to April time period. As I mentioned in the introduction, average monthly returns for the May to October months is just 0.23% compared to 1.16% for the November to April months.
Let me be clear here: I am not suggesting that 401k investors employ an aggressive market timing strategy with their retirement nest egg. History has proven that most investors are terrible market timers. And part of the 401k plan’s appeal is the ability to systematically save for retirement using regular contributions from your paycheck.
But, if you are to play the odds, you are more likely to enjoy better returns in the November to April period, so making any large contributions early enough to get in front of that period makes all the sense in the world.