Most people think of their 401(k) administrators as well-dressed men and women who spend a great deal of their time with their arms folded, staring off into the middle distance. That's because financial experts are always portrayed that way in advertisements.
In fact, 401(k) managers are just like anyone else, except that they sneeze gold dust. But, being human, they do tend to choose the largest funds with the best past performance to include in a plan. That's not always the best choice.
Fortunately, you can do a few things to help offset your 401(k) plan's bad tendencies - and your own, for that matter.
Most people look at a fund with a superb long-term record and think, "That's the fund for me." The problem with investing in the biggest and best funds is that they often don't stay the biggest and best.
One reason: Large funds can be cumbersome to manage. Fidelity Contrafund, for example, had 13.7 million shares of Apple as of March. 31, according to Morningstar. The fund couldn't sell the entire position in a day, even if it wanted to. And stocks of small companies would contribute little to the fund's $60 billion portfolio.
More important, however, many large funds have fared well because their investment style has been in favor. When that style goes out of favor, the fund's performance tends to languish along with every other similar fund.
Let's take a look at the 25 largest stock funds of 2007, which accounted for 28% of all the assets in stock funds at the time. The funds averaged a 1.6% loss the five years ended 2011, vs a 0.4% loss for the average stock fund, according to Lipper.
What's more remarkable is the disparity between the funds that gained the most in net new investor money and the funds that saw the most flee. The funds that investors poured money into, a net $123 billion in new money in 2006, rose an average 1.9% - and that's including a 139% gain by the fund industry's darling, the SPDR Gold fund.
The funds that investors pulled the most money from, however, gained an average 7.1%. Why the disparity? Back in 2006, the U.S. stock funds that fared the best were bargain-hunting large-company value funds, which gained an average 18.2%. The only diversified funds that fared better were large-company value funds that invested abroad. Large-company foreign value funds jumped 26%. So investors - including the folks who run your 401(k), most likely - jumped into value funds and foreign funds.
Unfortunately, banks have long been a favorite playground of value funds, and bank stocks cratered in the last bear market. As for foreign funds, well, there's that whole Europe thing.
In the meantime, stocks of companies with high potential earnings growth - think Apple - have been the winners. Not surprisingly, one of the most unloved large-company funds in 2006, American Century Ultra, has gained 25% the past five years.
Large funds do have some advantages. They often charge less in expenses and pay less per share in trading commissions than smaller funds do. Large funds can also afford to recruit top-flight managers, presumably ones who won't spend too much time staring off into the middle distance.
But if you're evaluating your plan's 401(k) offerings, consider a strategy first formulated at Morningstar: Buy the worst-performing big fund in your 401(k). The manager probably didn't take stupid pills. It's more likely that his investment style is simply out of fashion.
Bear in mind that investment fashions can last a long time. You'll need patience as you wait for your unloved giants to get better.
Remember, too, that depending on the capital markets for your retirement means you're relying on the one thing you can't control: the future.
But you can control how much you pay for your funds, and how much you add to them. Fortunately, many 401(k) plans give you access to institutional shares, which have lower costs than retail funds. And the best way to increase your retirement kitty is to add more money. You might not be able to sneeze gold dust, but bumping up your contribution rate to 6% from 3% could mean a faster route to retirement.
By John Waggoner