Are You Your 401(k)'s Worst Enemy?

Researchers examining how people invest their 401(k) funds have found that they confuse quantity with quality. As a result, they invest in whatever their plan offers the most of.

Convenient, yes. Smart, no.

Jeffrey Brown and Scott Weisbenner of the University of Illinois and Nellie Liang of the Federal Reserve found that the more choices in a particular type of investment -- stock funds, bond funds, company stock, and mixed funds -- the more money people allocated to that type of investment.

So a company offering a lot of bond choices would see employees put too much of their money into them.

The real-world impact? Since most investment offerings in 401(k) plans are high-cost actively managed mutual funds and not low cost index funds ...

"... because the average share of assets invested in low-cost equity index funds declines with an increase in the number of options, average portfolio expenses increase and average portfolio performance is thus depressed."

The researchers found other indications that people pay too little attention to their 401(k) plans:

• people allocate their money based on past performance, not on expected returns. So a five year run-up in stock prices -- which would make professional investors cautious about a bear market -- causes 401(k) investors to invest more of their money in stocks.
• similarly, there seems to be significant inertia in how people adjust to new choices. This indicates people aren't paying attention to their 401(k) options or performance.

They noticed other odd effects as well.

What is clear from their research is that people are not taking the time to think about their 401(k) choices and costs. They seem content to leave their plan on autopilot. That's a serious mistake that could have real long-term costs due to misallocated assets and too-high expenses. It could mean missing out on tens or hundreds of thousands of dollars in appreciation.

That's no way to treat what, for many, will be their primary source of retirement savings.

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Links:

NBER abstract, June 2007

2006 version of paper (pdf)