Blog | Paper Assets, Personal Finance

Redefining Risk

Why seemingly “safe” investments — namely your 401(k) — might be the riskiest of all

How do you feel about risk? Do you love it, or does the mere thought of it send shivers up your spine? Now, put risk in the context of investing — is that combination the stuff of nightmares? I guess it all depends on how you define risk.

What is the definition of risk?

Warren Buffett says, “Risk is not knowing what you are doing.” Now, the key word here is you, not the investment.

Personally, I define risk as: Reckless Investing Sans Knowledge

For instance, my stockbroker friend Tom offers this rule when it comes to investing in stocks: If you don’t understand how the company makes money, then don’t invest in it.

As always, if it looks too good to be true, then it probably is.

What appears safe may very well be (very) risky

Safe or risky? Those words need to be redefined when it comes to investing. Here are three common places you can “invest” your money — and traditional financial advisers have deemed them as safe:

1. Savings

2. Mutual funds

3. 401(k)s

Are these safe or risky? The typical financial planner will tell you they are safe. I say they are risky. Why?

Savings

With the dollar and other global currencies decreasing in value, your currency is worth less and will buy you less in the future. On top of that, the interest you are paid by the bank for your savings may earn you less than the fees and expenses you have to pay to keep your money in the bank. By saving money, in many cases, you are losing money. Would you call that a safe investment or a risky investment? An investment that consistently loses money is a liability, and that’s risky in my book.

Mutual funds

A mutual fund is simply a collection of stocks, bonds, and other similar securities. It could also be a company that pools the money collected from many investors and then invests those funds in stocks, bonds, and other similar paper assets. The mutual fund companies, the managers, and the salespeople — they all make money whether you do or not. Most are not concerned with the actual performance of the fund. They are mainly concerned about their fees.

Here is the reality of mutual funds according to John C. Bogle, the founder and CEO of Vanguard Group:

"Well, it’s awesome. Let me give you a little longer-term example I use in my book of an individual who is 20 years old today starting to accumulate for retirement. That person has about 45 years to go before retirement—20 to 65—and then, if you believe the actuarial tables, another 20 years to go before death mercifully brings his or her life to a close. So that’s 65 years of investing. If you invest $1,000 at the beginning of that time and earn 8 percent, that $1,000 will grow in that 65-year period to around $140,000."

"Now, the financial system—the mutual fund system, in this case—will take about 2.5 percentage points [in fees] out of that return, so you will have a gross return of 8 percent, a net return of 5.5 percent, and [in that 65-year period] your $1,000 will [instead] grow to approximately $30,000. $110,000 goes to the financial system, and $30,000 to you, the investor. Think about that. That means the financial system put up zero percent of the capital, took zero percent of the risk, and got almost 80 percent of the return. And you, the investor in this long time period, an investment lifetime, put up 100 percent of the capital, took 100 percent of the risk, and got only about 20 percent of the return. That is a financial system that is failing investors because of those costs [fees] of financial advice and brokerage, some hidden, some out in plain sight, that investors face today. So the system has to be fixed."

401(k) plans

A 401(k) is a retirement plan, often considered a retirement savings plan, set up by employers that allows employees to contribute a portion of their salary into this plan. A 401(k) plan invests the employee’s contribution into mutual funds. Similar plans exist in other countries under other names such as a superannuation plan in Australia and New Zealand, an RRSP in Canada, a 401(k) in Japan, and a pension scheme in the United Kingdom.

Recently, I met a young woman in her early twenties who had just landed her first big job right out of college. She told me excitedly about her salary, her signing bonus, and her 401(k).

"So what exactly is in your 401(k)?" I asked.

She looked a little confused. "Well, it's a standard 401(k). My employer matches my contributions."

"Yes, but what exactly goes into your 401(k)?"

She had no answer. I didn't expect her to. Very few people know exactly what they're getting in their 401(k) or how much it's actually going to cost them.

Millennials especially have little understanding of their retirement plan at the beginning of their work life. To them, retirement is decades away, something to worry about when their knees start aching and their kids go to college.

They have some idea of how they will pay for retirement, but aren't taking active steps to put a plan in place. Many of them see investing in a 401(k) as a solid plan for right now, until they can earn enough money to invest more substantially. But what they don't realize is that what goes into these plans is a recipe for disaster — and that’s because they have no idea how to define risk yet.

The 401(k) recipe

I've said it once and I'll say it again: the 401(k) is the single worst way to invest your retirement savings.

Thousands of Americans rely on employer-sponsored retirement plans, but they have no idea what they're paying for or where their money is going. They sign away control over their retirement, and don't think about trying to get it back until it's too late.

The 401(k) has become less of a retirement "plan" and more of a retirement "cross your fingers" recipe, with lots of unhealthy ingredients thrown in. With a lack of financial understanding, and some strong misunderstandings about where their money is going, Americans have relinquished control over their future, leaving them with an absolute mess.

Which leads me to my question: Do you know what's really in your 401(k) “plan?” Let's walk through some ingredients you didn't know were packed into your retirement plan.

1. Hidden fees

   The first thing you should know is that your 401(k) is sprinkled with hidden fees that are buried in pages of legal paperwork. Legal fees, transaction fees, bookkeeping fees, and more. Plus, the mutual funds in the 401(k) often take 2% off the top.

   These fees may not seem like a lot when you sign on the dotted line, but overtime, compounding cuts down your returns substantially. Jack Bogle, the Founder of Vanguard, puts it like this: "Do you really want to invest in a system where you put up 100 percent of the capital, you take 100 percent of the risk, and you get 30 percent of the return?"

   The worst part? Most Americans are completely unaware that there are any fees on their 401(k) or that they’re paying them.

   These hidden fees water down the returns, destroying all your well-intentioned saving and investing. If you don't know about these fees, you're putting your money (not to mention your future) on the line.

2. No knowledge or control

   The worst part of the 401(k) recipe is that you aren't even the chef in this game. Instead, you're sidelined, watching other people prepare your retirement buffet for you.

   As an employee, you have absolutely no control over your investment. If you were to take your money and invest in in the same mutual funds and stocks as the 401(k), but on your own terms, you would already have 100% more control over your money than an employee who goes with the employer-sponsored program.

   That's because most employees don't get to opt out of the 401(k). And when they invest, they have no voice in which mutual funds they put their money into.

   Would you ever make a purchase where you don't know everything you're paying for? When you buy a house, a car, even a shirt at the mall, do you just blindly hand your money over, hoping for the best? Of course not! But that's what happens with a 401(k) plan.

   When you put your money in a 401(k) you rely on other people to conduct due diligence and invest in quality funds that uphold your philosophies and produce a return. But you will never meet the people investing your money. You'll never have a conversation about your financial goals or your retirement plans. You'll never look them in the eye, instead you'll just hand over your money and hope for the best.

   That's not a retirement plan. That's jumping off a cliff without a parachute.
    

3. External factors

   When you cook a recipe, there are lots of things that can go wrong that are out of your control. Your oven could overheat or your ingredients could be out of season. In the same way, the 401(k) relies on and is governed by multiple external factors, reducing your control over your investment even more.

   For example, the 401(k) depends on the stock market. Whether the market rises or falls, your money pays the price. You could lose half of what you've put away overnight if the markets fail. Your retirement hangs in the balance and you have absolutely no control.

   In addition, the 401(k) is subject to government control — and as we all know, Washington can change its mind pretty quickly. The rules and regulations governing your 401(k) could be altered, new laws can be passed, and you could be dealt a very poor hand.

   When you add it all up, here’s what a 401(k) provides:

   Hidden fees + No knowledge/control + External factors = Your Retirement

   Yikes, that sure doesn't instill confidence, does it? That's because the 401(k) leaves you powerless, subject to hidden costs and the tides of the stock market, with no say in anything but your contribution amount. If you follow this recipe exactly, you'll end up with a mess for a retirement.

Risky versus safe investing tactics

In the world of investing, there are no investments that are 100 percent guaranteed. There is no investment that is absolutely safe (safe meaning “free from losses”). There is no risk-free investment. When you invest your money, you will win and you will lose. That is a guarantee. Yet there certainly are things you can do to reduce the risk and increase the safety.

In summary, what is risky and what is safer?

Risky

• Having no financial education.

• Blindly turning your money over to a financial planner or adviser.

• Not understanding the investment and the returns on the investment.

• Putting up the majority of the money and the risk and letting others walk away with the majority of the returns.

• Having no control in your investments.

• Depending heavily on a financial adviser.

Safe(er)

• Getting financially educated.

• Actively investing your money and gaining hands-on experience.

• Understanding the investment and the returns on the investment.

• Putting up the majority of the money and the risk and getting the majority of returns.

• Having control in your investments.

• Becoming your own financial adviser.

It's time to take back control and become the chef in your own kitchen. It's the only way to ensure you have a secure and prosperous retirement, cooked just the way you like it.