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Margaret Collins of Bloomberg recently reported some good news about the portfolio allocation of younger American investors in their 401k plans, which noted that young investors are increasing their allocation to stocks (and rebuts the wisdom coming out of some quarters that the financial crisis has continued to deter young investors from making stock investments). According to the report:

"About 60 percent of 401(k) investors in their 20s had more than 80 percent of their accounts invested in equities at the end of 2010, compared with about 55 percent of investors in 2010, according to a report by the Investment Company Institute, a trade group for the mutual fund industry, and the Employee Benefit Research Institute, a nonprofit group … The number of younger workers with no equities in their 401(k) accounts also decreased at year-end 2010 to 9.4 percent from 14.6 percent in 2000, said Jack VanDerhei, research director at EBRI." (Source)

This, of course, is good news on the surface. While it's necessary to always include the obligatory disclaimer about how everyone's situation is different and it's hard to make hard-and-fast generalizations when it comes to personal finance, this does seem to be in the best interests of investors if they manage to keep their stock holdings over the course of the next several decades. I would say that it's more likely than not that investors who put their money into stock funds at the age of 25 and hold until the age of 55 will perform better than those who put their money into bond or money market funds. (Ha! For those of you with a sense of humor, check out this link by Matt Krantz of USA Today. (Source) After I wrote the previous sentence, the very first article that showed up on the USA Today homepage was titled "Why are Bonds Outperforming Stocks Over The Long Term?," which noted that bonds have returned 11.03% over the past thirty years while stocks have returned 10.98%).

But, of course, therein lies the rub. Jack VanDerhei, the researcher at EBRI, has this to add about the increased stock allocation of young investors:

"A lot of that may not necessarily be due to employees themselves actively making that choice as much as it's them being automatically enrolled, being put in target-date funds." (Source)

While this is a somewhat subjective statement, it does raise a very significant potential concern about the portfolio allocation of young investors-namely, that if the allocation of their 401(k)s simply reflects the autopilot options that are set as the default of employment, then it calls into question whether investors know why they own the stock holdings that they do.

When I mentioned earlier that an investor can do very well with his stock holdings in his 401(k) that he holds from age 25 to 55, that assumes an interrupted period of investing and compounding that is simply not the reality for a lot of people. In addition to the normal vagaries of life which would force someone to withdraw from a 401(k), there is also the potential that an investor may get panicky during a downturn and sell his stock holdings at a low point, such as late 2008/early 2009.

This is especially true if an investor is merely investing on autopilot, such as Mr. VanDerHei claims. In my opinion, it is the investors who know why they own something that will most likely be able to weather the periodic 30-50% declines in the stock market without letting irrational fears lead to a sell decision.

Let's consider the case for investors in each of the four following companies: Coca-Cola (NYSE:KO), PepsiCo (NYSE:PEP), Johnson & Johnson (NYSE:JNJ), and Proctor & Gamble (NYSE:PG). Each of these four companies saw share prices decline by at least 35% from a high to a low at one point in the past decade, yet each of these companies managed to grow per share earnings significantly over the decade stretch from 2001 to 2011. Coke grew earnings per share from $1.60 in 2001 to $3.87 in 2011, Pepsi from $1.66 to $4.35, Johnson & Johnson from $1.91 to $4.96, Proctor & Gamble from $1.56 to $3.93. Even though the earnings growth of each of these companies managed to grow almost every year, that was by no means true for the stock price-the price of admission for enjoying 8-11% annual gains in the stock market is that you have to weather the annual volatility of the stock price which is out of your control. But I think that if investors know why they own a given investment, it's much easier to hold during times when the temptation to sell arises.


(Click to enlarge)

I included a picture of some of the products that Coke, J&J, P&G, and Pepsi offer-if you can recognize that owning stock in each of these companies translates into earning a fraction of a fraction of a fraction of a cent every day that millions of people buy these products, then it becomes very easy to ignore the animadversions of the doom-and-gloom market pundits and Mr. Market that might tempt you into locking in a permanent loss.

This is why I'm concerned about Mr. VanDerHei's comment that many young investors might just be riding on the company's autopilot selections with their retirement investments. If an investor just treats his retirement funds as three or four letter blips on a screen that occasionally experience substantial declines, then the impulse to sell when a $75,000 portfolio turns into $50,000 over a short period could become too overwhelming to ignore. While I think it's very good news that young investors are investing more in stocks within their retirement accounts-time is compounding's best friend-I think that it is absolutely necessary that investors should be able to explain why they own each of their investments, lest they enlarge the temptation to sell during a market decline. After all, the quickest way to nullify the benefits of increased stock ownership is for the investor to shoot himself in the foot by selling during a market hiccup.

Source: Good News And A Caveat For Young Retirement Investors