WASHINGTON — Do you think the stock market looks overpriced? Remember that if you participate in a 401(k) plan, there's a good chance you are buying in at today's prices every time you get a paycheck.
And that means the rules of investment are different for you than they are for the people who invest larger sums less frequently. Unfortunately, most investment advice is written for them.
Take, for example, the performance data that most investment advisors use when picking mutual funds. Typically, they will point to a fund's one-year, three-year and five-year returns and favor the fund with the highest long-term returns.
But those returns are calculated using lump-sum investments, reports David Huntley of the Baltimore research firm HR Investment Consultants. They are based on the hypothetical investor who puts all of his or her money into a fund on one day and then lets it sit there for 20 years--the traditional buy-and-hold investor.
If, instead, you are investing through payroll deductions, you're more of a buy-and-buy-and-buy-and-hold investor. Surprisingly, the funds that perform best under those circumstances are different from the lump-sum top performers.
Huntley had the Value Line Mutual Fund survey evaluate how two top funds would perform under two kinds of investment scenarios.
In the first case, Value Line assumed that $10,000 would be invested in Mutual Shares Fund and in CGM Capital Development Fund. At the end of 20 years, the Mutual Shares investor had $393,574, beating out the more volatile CGM fund by $67,000.
But if the same investors added $100 each and every month to their accounts during that 20-year period, the tables turned. The Mutual Shares kitty fell almost $92,000 short of the CGM's $691,847 nest egg.
Why? The CGM fund was more volatile during that 20-year period. It enabled the regular $100-a-month investor to capitalize in the down times and minimize exposure to the highest prices.
When you invest through regular paycheck purchases, you are employing an investment technique called "dollar cost averaging." That means that every investment period, your average share cost rises or falls with the market. In February, your $100 payroll deduction buys 10 shares of a $10 fund. In March, it buys five shares of a $20 fund. In April, it buys 20 shares of a $5 fund.
This isn't news to anyone who can do simple division, but the implications for retirement investors might be. Imagine dollar cost averaging into a staid, low-risk fund that grows gradually.
Your $100 a month buys roughly the same number of shares every month as it ebbs and swells from $18 a share to $21 a share. But if you instead picked a hold-on-to-your-hat roller-coaster fund and sent it $100 a month for 20 years, you'd have a better chance of buying in bulk during the inevitable (and, some say, imminent) market crashes, corrections and other disasters.
Put another way, you don't just want stock funds in your 401(k), as you've been taught. If you have a long-term horizon, you want volatile stock funds there.
Linda Stern can be reached via e-mail at email@example.com or by mail in care of Reuters, Suite 410, 1333 H St. NW, Washington, DC 20005.