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The Investment Everybody Needs
Mid-November, the fall season, a metaphor for retirees and late-stage professional athletes, and the beginning of hope for Dallas Cowboys fans unlikely to be realized as their team attempts to make the Super Bowl after 27 years of futility. It is Thanksgiving week, the shopping season, and that time in the semester when my students study investments, common investment strategies, asset allocation, and the evidence that actively managed mutual funds are not worth the expense structure imposed by their management teams.
My SMU audience is in their spring season. Many are eager to learn; most think a university education is a path to a better job because it is. Depends on the talent and drive of the student, but on average, college grads are compensated better than the less educated cohort. Preston Taylor knows. In his case, more education had expected benefits that exceeded expected costs.
Whatever the household’s life cycle season, if one or both members become a new hire, they may get a surprise from the HR department. Their employer may offer a defined contribution plan (401(k), 403(b), or thrift savings) that includes an employer match indicated by a phrase similar to the following:
“We will match your contribution fifty cents on the dollar up to 6% of your salary.”1
Reads like additional compensation. However, the employer match, when offered, is not 100% utilized by employees. In a 2015 study, Stephen Miller at the Society of Human Resource Management (SHRM) reported that about 25% of employees do not take full advantage of an employer matching program. Among 1,700 plans managed, Vanguard reported in their 2022 survey “How American Saves 2022,” that about 31% of plan participants do not take full advantage of the employer match. Is it a mistake to miss the match? Conventional wisdom is the employer match is “free money.” Don’t bite through completely on that statement; nothing is free.
There is a near-term give-up in consumption, moderated by an income tax advantage when an employee must save to receive this additional compensation. To illustrate, an employee with a salary of $75,000 and the match described above could make the elective deferral of $4,500 (6% of $75,000), lowering taxable income to $70,500 under present law. On the margin, income tax would be lower by $990, plus the employer is kicking $2,250 into the employee’s retirement account. Still, the $4,500 deferred is no longer available for consumption.
On the Radar: How to Invest
Whether a match is in play or not, the question is how an employee should invest. A default selection toward equity exposure via a target date fund is a good first step for the average person.2 That doesn’t always happen. Recent research has found that federal employees offered an employer match were inclined to have 41% of their portfolio in the low-risk, low-return “G Fund.” In a large-scale study of 401(k) plans, a recent working paper by Harvard faculty published via the National Bureau of Economic Research finds that more highly educated individuals allocate a higher percentage of their portfolio to equities. Education is important. But what about those less educated?
Subscribers to Personal Finance Economics know that having dollars to save and invest results from a carefully crafted financial plan. Proper investments are in order when savings and investments are part of that plan. But how should that be done? It is easy with the guidance of the right book, and I assert that view applies to the population of those with at least a high school education.
Some might say: “Puelz, you have selection bias. Understanding how to invest is hard.” Granted, I write within the dry lab of B-school populated by my students, staff, administrators, and other faculty. Starship robots move about campus, delivering drinks and food to those with an app and a penchant for lying down—a resort resting atop the foundation of a mortar board.
However, my students bring very different interests and intellectual strengths to the north side of Mockingbird Lane. A tennis player from SoCal, a budding psychologist, a history major, a sports management major, and even a couple of econ majors. Some are “financy;” others have been telling faculty who would listen: “I am not very good at math.” I always wonder about that statement. Didn’t they have to have an acceptable SAT score? In the ways of investment background, though, average is the norm.
We all live in a basic commercial world of Walmart, Home Depot, Costco, CVS, and ln-N-Out. An investment book should be just as accessible. Broad appeal informs my recommendation for the investment that everybody needs,
Give a loved one the 2023 version of Burton Malkiel’s “A Random Walk Down Wall Street.”
Recent past versions, the 2020 edition, are fine, too. The writing is clear story-telling around content in which the writing follows peer-reviewed evidence. Malkiel discusses investments, investment strategies, and important topics such as asset allocation, e.g., how one actually invests. Readability is an A+ for the newbie to business and finance, and the conclusions are essential for CFPs.
What drives the recommendation? It combines Malkiel’s accessible writing, history of finance, and summaries of contemporaneous academic research on the markets. For example,
Well known among financial economists is that investment managers who are in the business of making stock picks do not regularly produce returns that outperform the returns from the comparable market index.
The chart below shows a restatement from Malkiel that shows how returns from investing in a benchmark have fared relative to actively managed funds. Over five years and 15 years, the performance of benchmarks has dominated the performance of actively managed funds. Only basic information about how to find the benchmarks and invest in them is vital for successful investment over the long term.
The reasoning behind why stock-picking is unnecessary has an explanation that is intuitively appealing. Stock-pickers, fundamental and technical analysts, rely on public information about publicly traded companies that is abundant and free-flowing. Many pros have been trained in business schools, and the valuation principles learned by every undergraduate and MBA are core educational content. How could one take advantage of another in a trade by being a better stock-picker? For every buyer, there is a seller. Investing strategies are not unique; if an investment guru had one, it would never be shared with a clientele. Moreover, if it is shared with a clientele and word is leaked about a strategy or money manager with the special sauce, it will be replicated, and any prospective supernormal performance will be bid away.
The good news is Malkiel has built a path for an investment walk anyone can follow: invest savings in the appropriate index fund, retain some money for investment enjoyment, and avoid the guaranteed loss of a return imposed by actively managed investment management fees. Here is my take on the script:
Invest in an index fund. Preferably a total market index fund. You will be diversified for risk about as much as you can and incur very low expenses, which means more investment dollars in your pocket. The table below shows a sample of exchange-traded funds (ETFs) from Malkiel (2020) updated for today’s net expense ratios.3
Investor-savers can reduce dramatically the certain expenses associated with active fund management and move to the investment company’s offering of the comparable index fund which diversifies the risks which are company-specific.
Investing a small percentage (5 - 10%) of savings in individual stocks for fun is fine. If choosing among companies focused on the same industry, select the company with a lower PEG ratio and a higher expected 5-year growth rate in earnings. A price that is lower relative to earnings forecasted and the prospect of growing earnings over a longer period signals better prospects that may help with the downside risk of an investment.
Consider the vibe. Read the credibly informative financial press, e.g., the Wall Street Journal, Barrons, etc. The content of the press a company receives may speak to reputation risk, an announcement about prospects, or news that a company’s operations have gone south. Investors will react to the information instantaneously, but the general tone about a company or sector, if negative, may be important in the near term.
There is much more in the full text to value. It is a year-end gift and investment everybody needs.
85% of Vanguard-managed defined contribution plans in their 2022 report on 1,700 client firms include a matching feature. See page 17. The structure of these features varies, but most often, it is stated that an employer will contribute some fraction of a $1 per $1 of employee contribution up to a certain percentage of annual salary. Vanguard calls this a “single-tier” match.
Target date funds are asset allocation funds linked to an investor’s prospective retirement date. A higher percentage investment in equities is a feature of these funds with a target retirement date farther into the future. Recent evidence suggests younger 401(k) investors are more likely to be in target date funds. Holden, Sarah and VanDerhei, Jack and Bass, Steven, Target Date Funds: Evidence Points to Growing Popularity and Appropriate Use by 401(k) Plan Participants (September 9, 2021). Available at SSRN: https://ssrn.com/abstract=3923143 or http://dx.doi.org/10.2139/ssrn.3923143