Cumberland Advisors is a fiduciary advisor for retirement plans such as 401(k)s for businesses, 403(b)s for education and nonprofit groups, and 457 plans in the government sector. As part of our advisory efforts, we meet with plan participants to help them assess their retirement account needs. Most plan participants are intimidated by the various mutual funds that are listed for them to select. The fact is that even when the retirement plan is structured correctly, there are still individual choices that have to be made.
In this commentary, I am going to reveal one of the most simple and useful methods to invest a retirement account if you are very young, if your account is very small, or if you are just beginning to save for retirement. This method is not advisable for someone who is nearing retirement or who has a large balance saved already. Seek more specialized advice in those circumstances.
Here is that simple advice: Invest in one broad equity security over time (most likely the indexed S&P 500) and keep sending your money in each payment period, month in and month out, year in and year out. That’s not complicated at all. Remember, this is most relevant if you are early in your career (decades away from retirement) and/or have a small balance.
Most people have heard about diversification as a way to mitigate risk. However, diversification across asset classes (stocks, bonds, alternatives, etc.) helps mitigate risk only when there is actually money enough to risk losing. If, however, you are just beginning, with a long time horizon ahead of you, diversification across asset classes is the wrong approach.
A retirement plan has a feature, unique from other investments, that inures naturally to management of risk and diversification. That feature is the fact you keep sending new contributions in, check after check, month in and month out. Then, rather than diversification by asset class, you have diversification by time. I credit this idea to Ric Edelman in his book The Truth About Retirement Plans and IRAs (New York: Simon & Schuster, 2014, p. 86; www.amazon.com/Truth-About-Retirement-Plans-IRAs/dp/1476739854).
Because new money is being pulled from your earnings each pay period and sent for investment, diversification by time leads to natural dollar cost averaging (DCA). Dollar cost averaging occurs when you purchase the same security in up or down markets, thereby securing lower average purchase prices over full market cycles. When the market is going up, you continue to buy incrementally at higher prices, thereby staying invested. When the market is going down, you buy incrementally at lower prices, thereby lowering average total costs per unit. As the equity market tends to rise over long periods of time, buying consistently in both up and down markets has delivered good results.
An indexed mutual fund that covers the S&P 500, for example, provides solid diversification. The S&P 500 is an index of the 500 largest US companies, listed on the NYSE or NASDAQ. It excludes privately held companies, such as Cargill, and foreign companies not listed on either exchange. The S&P 500 captures currently 80% of the total domestic US stock market capitalization. (Source: https://www.gobankingrates.com/investing/things-investor-should-know-sp-500-index/). Additionally, approximately half of the revenues for the S&P 500 come from non-US markets. (Source: “S&P 500 companies generate barely over half their revenue at home,” by Steve Goldstein – www.marketwatch.com/story/sp-500-companies-generate-barely-over-half-their-revenue-at-home-2015-08-19). Thus, just buying the S&P 500 gives you access to global markets at some foundational level.
As a recap, the advice in its simplest form is to find an indexed S&P 500 mutual fund available in your retirement plan and invest 100% of your future contributions to it. No other diversification is needed when you have a small balance and a long-term investment horizon. You are getting approximately 80% of the total market with global revenues built in, within the domestic market and US law. That is easy and actually works great.
Now here is another little secret: Indexed S&P 500 mutual funds are now very inexpensive with internal fund fees somewhere around 5 basis points per year (.05 of 1% per annum, or about 5 cents for every $100 dollars invested). That may be the best deal in the history of investing. All retirement plans, by law, are supposed to have at least one indexed S&P 500 mutual fund available to be used. However, you may find that the internal expense ratio of that indexed fund is a lot more than 5 basis points. Some are as high as 60–70 basis points for the exact same thing! If you find this, then you will have run into an embedded conflict of interest related to your plan. You should still use the fund in the interim, but you now know to ask further questions of your company’s retirement plan administrator or owners. Start by asking whether the financial providers/advisors involved are fiduciaries. That will open a can of worms related to embedded conflicts of interest in the plan that is worthy of opening. But that is a subject for a different day.
In summary, buying the S&P 500 early and often in your retirement plan if you have a longer-term horizon is sound advice. It is also simple. Of course, no investment is free of shorter-term market changes. Yet, long-term investing in a diversified index of equities has shown to have superior results. Some people may want to make slight adjustments to this strategy depending on what is available to them in their retirement plans and other considerations specific to their personal financial needs. This may include other variants of the S&P 500 (for example, equal weighted rather than capitalization weighted). It may also include sleeves of mid-cap companies, small-cap companies or even simply the total market. But the basic principle still holds: buy the market, keep the internal fees low, and keep contributing over time using dollar cost averaging. It is a simple principle that is available to everyone in every retirement plan.
