The history of 401k Investing
Posted on: 04/02/2015
Today’s Throwback Thursday article (below) may be the most historical one we will ever post! In October 2014, iSectors’ CEO Vern Sumnicht was quoted in an article on FiduciaryNews.com entitled “Explaining 401k Investing Basics Through the Lens of History.” The article covers the history of stock market investing starting with period leading up to the Great Depression, and the laws that were passed after the Depression to help Americans dig out of the deep hole we had found ourselves in.
The author closes with details on a chronological series of events that led to where we currently are in today’s investing landscape, and how that all relates to the 401ks — which puts a nice bow on top of it all. FiduciaryNews reports on everything that lies within the 401k space, which is very fitting since iSectors also offers a few growing 401k solutions designed specifically for financial advisors to utilize.
Explaining 401k Investing Basics Through the Lens of History
By Christopher Carosa, CTFA | October 14, 2014
A terribly unexpected thing happened on Tuesday, October 29, 1929, so terrible that that particular day became known as “Black Tuesday.” OK, maybe it wasn’t that unexpected. After pressing stratospheric highs into the late 1920’s, the actual decline began in September of 1929. It continued into early October before the selling frenzy started in earnest on Friday, October 18. The first “Black” fall occurred on, appropriately named, “Black Thursday,” October 24th. There were some feeble attempts to settle things down (although with the usual Black Helicopter theories as to why these attempts failed), but the following Monday (also given the moniker “Black”), saw a far greater drop. Panic selling had set in. Then, on Black Tuesday, the bottom fell out. (Oddly, Black Monday saw a greater percentage drop than Black Tuesday, yet the 29th gets all the credit.)
One thing the 1929 stock market crash shouldn’t get credit for it the Great Depression. It may have accelerated the economic calamity, but most site the policies of Hoover and Roosevelt as the prime reason the American economy fell apart. This doesn’t mean it wasn’t indicative of significant problems within the capital markets themselves. There were, and, to his credit, Roosevelt let the way in truly stabilizing equity exchanges. In a flurry of activity, the government created The Securities Exchange Act (two of them in fact) laying the groundwork for the markets as we know them today.
“The Securities Exchange Act of 1933 (33 Act) was designed to provide some basic rules of engagement, level the playing field and assign some accountability to protect investors,” says Vern Sumnicht, CEO of iSectors in Appleton, Wisconsin. “The objectives of the 33 Act were to require that investors receive all material information about securities being sold and to prohibit fraud, deceit and misrepresentation of information. To accomplish these objectives the 33 Act requires disclosure of important financial information through the registration of securities. This is to allow investors to make informed decisions. The 33 Act provides for accountability by giving investors who purchase securities and suffer losses, important recovery rights if they can prove that there was incomplete or inaccurate disclosure of important information.”
The 33 Act was followed immediately by a similar act in 1934 and by the dual Acts that set the adviser industry framework in 1940 – the Investment Company Act of 1940 and the 1940 Investment Advisers Act. While Washington was firming up the rules, leading financial thinkers of the day were trying to formulate ways to study individuals stocks, rank individual stocks and determine the best time to purchase individual securities. In case you’re wondering, this was the onset of the era of individual security analysis. Benjamin Graham, who, together with David Dodd co-authored the book Security Analysis in 1934, has been ordained the Father of Value Investing.
“Value investors seek investment opportunities to purchase assets at a discounted value and hold them until the market realizes their inherent value and the price of the asset appreciates,” says Liam Timmons, President of Timmons Wealth Management in Attleboro, Massachusetts. “Value investors often focus on companies with low valuations (relative to historical levels or peers or the market overall) where the current value of the company is below its long term potential. Oftentimes, this can mean buying companies that are undergoing short term operational challenges, management changes or are struggling with newly emerged competition where the belief is that the market is overreacting to short term issues or vastly underestimates the growth or earnings potential of the company.”
A competing form of securities analysis quickly countered the popularity of value analysis. While there is no clearly recognized “Father” of growth investing, one of the early practitioners was Philip Fisher, author of Common Stocks and Uncommon Profits. Originally published in 1958, the book remains popular today. Companies that can be classified as growth stocks “usually include visible growth in earnings, revenues and share price,” says Nicholas V. Ventura, President & CEO at Ventura Wealth Management in Ewing, New Jersey. “Investors who seek ‘growth companies’ often forgo traditional valuation metrics. Examples would include social media companies – wide reach but little in terms of profits. Chased for quick return growth companies that fail to deliver in revenue or profit are often punished terribly in market corrections. Since no one really knows what the growth will be they are often the first to be cut from portfolios in a market rout.”
Graig P. Stettner, a Financial Advisor at Strategence Capital, Fort Wayne, Indiana says value investing offers an advantage when “stocks that are despised by investors get assigned – by virtue of their prices being depressed – lower than average valuation multiples, reflecting investor pessimism. When the pessimism abates, there is a re-rating higher of the stocks’ valuations.” Likewise, he says there’s an advantage of the growth style “in that there are certain times when the economy is not growing and the tide is not lifting all boats. In those times, a growth company/stock may deliver what the average stock is not able to deliver, a rising stream of sales earnings. It is at times like these that a growth style may be in favor.”
For decades following the Second World War, advisers would debate the relative merits of growth versus value investing. Adam D. Koos, President and Portfolio Manager at Libertas Wealth Management Group, Inc in Dublin, Ohio, says, “Value investing is like going shopping for clothes and heading straight for the sale racks – high quality, but low cost. Growth investing is like shopping at the trendiest store with no regard for price, hoping that everyone will buy the same shirt you picked up off the display model.”
Many traditional securities analysts see the capital markets as the ongoing battle of two great forces: Momentum and Reversion. “Growth investors tend to focus on momentum, believing that companies growing faster than their peers make better investments, and that the stock price is of lesser importance,” says Tom Weary at Lau Associates LLC in Greenville, Delaware. “Value investors tend to focus on reversion, believing that all companies revert to the mean over time, and thus that it is better to buy troubled companies cheap stocks in the hope that both operating performance and valuation return to average. The danger comes in over-emphasizing either. A Growth investor can overpay for a stock which then stumbles, causing a collapse in the stock price. A Value investor can try to ‘catch a falling knife’ where a cheap stock gets cheaper as things unwind at a company.”
While this value vs. growth debate continued unabated, a new theory blossomed from the notes on one of Harry Markowitz’s napkins. Ultimately labeled “Modern Portfolio Theory” (or “MPT”), it would challenge the very assumption of security analysis, regardless which flavor – growth or value – you preferred. The ascendency of MPT led to a more portfolio-centric, rather than an individual stock-centric, emphasis. By emphasizing portfolios instead of individual stocks, statistics, not accounting fundamentals, became the dominant metric. This, in turn, led to the popularity of index funds (a.k.a., “passive investing”).“Since investing is a zero sum game – 50% win and 50% lose – you have a 50% chance of winning from the get go,” says Bradley Roth CFP, President, Kattan Ferretti Financial, Pittsburgh PA. “However you must add management fees, commissions, trading fees, taxes, etc. After you are done, most active management styles under perform. If low cost passive investing is done correctly, using proper diversification and rebalancing passive investors are likely to beat the majority of active investors over time. Passive investing will also eliminate many harmful emotional decisions. Historically emotion tends to be the major contributor to under performance. By eliminating ‘market timing’ emotional decisions investors are already ahead of the curve.”
The debate therefore shifted from “value vs. growth” to “active vs. passive.” Timmons says, “The key advantage of passive investing is lower costs and removing manager-associated risk from investing. By keeping costs low and seeking to track an index, investors can be better positioned to achieve average market returns over the long term. Strong bull markets where correlations are high among stocks can favor passive investing.” Alternatively, he says, “The key disadvantage of passive investing is the lack of downside protection; if you believe the market is not fully efficient and manager skill can steer a portfolio away from bad companies or risky investments during market turmoil, active investing can be positioned to provide better returns in declining markets. Passive investing can appeal to investors seeking to keep costs low and that lack the time or training to select active managers.”
More recently, we may be seeing the beginning of the debate between domestic vs. foreign securities. These debates are ongoing and, evidence would suggest, constantly shift. As good fiduciary is aware of all styles of investments, their advantages and disadvantages, and the types of investors each might be more appropriate for. “There is no ‘one size fits all’ retirement plan,” says Elle Kaplan, CEO & Founding Partner, LexION Capital Management LLC in New York, NY, “Investment style is complex and needs to take into account all of your financial goals, your current financial state, the risk you’re willing to take, the nature of the markets, what kind of a time frame you’re working with, and more. Assess your long-term goals (what age do you want to retire? what do you hope your life in retirement will look like? what are your legacy goals?), plan for your expected future needs, and build in room for unanticipated expenses. You would never just hop into your car without a clear idea of how to get to your destination. The key to a secure and happy retirement is to have a detailed road map that will help you navigate the terrain and get you where you want to go. That way, you can be sure to live out the retirement of your dreams.”
With that in mind, the challenge comes when the rubber finally meets the road and disciplined decision making is required. “The most frustrating experience I have had comes with convincing 401k participants to have patience and avoid chasing returns,” says Heather MK Wonderly, Senior Consultant at AKT Wealth Advisors LP in Lake Oswego, Oregon. She says, “‘Rearview mirror investing’ never pays off, but behavioral studies show it is extremely difficult for people to resist this temptation. Some of my larger retirement plan committees have chosen to stuff the genie back in the 401k bottle and only offer professional investment management to their employees. While this can be a wonderful solution for some, others find it to be too difficult politically.”
When it comes to research, though, we need to remember one thing: The most important components to successfully achieving a comfortable retirement including the three options outline by the 2012 Wharton study – saving early, saving more, and saving longer by working longer.
If you’d like to discover other important topics confronting 401k fiduciaries, then you’re invited to explore Mr. Carosa’s book 401(k) Fiduciary Solutions and discover how to solve those hidden traps that often pop up in 401k plans. His forthcoming book Hey! What’s My Number? – The One Thing Every Retirement Investor Wants and Needs to Know! will be available later this year.
Mr. Carosa is available for keynote speaking engagements, especially in venues located in the Northeast, MidAtantic and Midwestern regions of the United States and in the Toronto region of Canada.
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