In light of these changes, Wiser has altered our recommended ASA 401k Models. Please view the models HERE.

Click Here for PDF Version   Click Here For Vanguard Index Tier Information

By now you have received notice that there are some changes happening within the ASA JPMorgan 401k plan. The good news is some of the funds are getting cheaper. The frustrating part is this should and could have happened a long time ago. It should also be known that your ALPA Retirement Committee was not made aware of these changes any earlier than your receipt of the JP Morgan Letter. This is frustrating as the pilot group is the largest contributor to the ASA 401k plan and should have input into their retirement choices.

Despite the secretive and abrupt nature of this change, I will help you dissect these changes and help you figure out what actions you should consider.

Closures

On the “no longer available to us list” are the American Century Ultra and American Funds Growth Fund of America funds. These funds have recently underperformed their peers and or the S&P 500. The replacement for these funds is the JP Morgan Large Cap Growth R6 fund. There are some key measurements that we can look at to dissect if this change is in the participants’ favor.

Alpha – This is the fund manager’s ability to beat the index. In this case the index would be the Russell 1000 or the S&P 500. The higher Alpha, the better. A negative Alpha means the manager has earned too little based on the risk of the investment.

Sharpe Ratio – Most fund managers take on additional risk outside of their assigned index in order to beat the index. Sharpe Ratio does not mean a whole lot by itself. When comparing two funds you want the one with the higher Sharpe Ratio. This means that the additional risk has paid off.

Standard Deviation – This measures the volatility (risk) of the fund from its average rate of return. Ideally an investor wants a high rate of return with little standard deviation, which is hard to find. One certainly does not want a low return with a high standard deviation; this means that risk is not being rewarded with return.

Using the key indicators above we can compare our new JP Morgan Growth Fund R6 to the two outgoing mutual funds.

The data above shows that the mandatory transition from Ultra and Growth Fund of America is not a bad move. Notice how the standard deviation (risk) is virtually the same for all funds yet the end results are very different. This reflects the portfolio managers’ stock picking ability. The American Century Ultra fund has been an underperformer for years. American Funds Growth Fund of America has good ten years risk/reward data; however, it has under performed its peers in the last three years.

As a side note, over the long term 10 + years very few managers actually beat their assigned index. This is why 401k plans that offer Vanguard Index Funds are very desirable. Currently Fed Ex, Hawaiian, SouthWest and United offer 401k plans with a Vanguard Index tier as additional investment options.

Holdings

JP Morgan Large Cap Growth Fund holds 68 total stocks, compared to 310 in Growth Fund of America and 81 in Ultra. The JP Morgan fund has bought and sold (turned over) 84% of its portfolio over the last 12 months compared to 33% in Growth Fund of America and 24% in Ultra. The turnover percent within a fund is important as for every 100% in turnover adds 1.0 – 1.5% in fees paid by the participants.

The top five holdings (as of 9/30/2011) within each fund are as follows:

Fee Changes

Other funds within the ASA 401k plan had fee changes and new tickers assigned.

The new fees average out to be 0.15% in average reductions with the largest change being 0.20% in three mutual funds. In all the funds listed above, the holdings, investment objective and managers remain the same. Only the share class (fee structure) changed. I will note here that the JP Morgan letter shows the JP Morgan Equity Index fee as going from 1.19% to 0.10% in the new index. This has to be a typo as the old fee is published as 0.20%.

Why Did the Changes Take Place?

I have taken many phone calls from plan participants asking why these changes have taken place and what this means to them. The why part is very simple. JP Morgan has been collecting annually an estimated $356,000 in administration fees ($88 per plan participant), which is included in $1,234,000 in fund fees (avg 0.79%).

These fees are not terribly out of line with a plan of our size; currently 155 million in assets.

In my opinion these fees could have been lowered years ago. However, the company certainly has more leverage recently because of the purchase of Express Jet. A joint ASA ExpressJet 401k plan is valued at $400+ million. JP Morgan wants that business and as a result has lowered its fees. With our new fee structure, JP Morgan will still be collecting $238,918 in administration fees ($59 per participant), which is included in $1,072,000 in fund fees (avg 0.69%) just on the ASA 401k, not including Express Jet’s 401k.

This is where competition and larger plan assets benefit the plan participant (you). While this is great news, there is still work to be done. Even though our fund expenses have dropped, we can still do much better.

Three Ways to Invest

There are three ways to invest in the stock market. I love Coca Cola, so lets use cola as an investment example.

I.  Stock

Let’s say we invest $5,000 into Coke stock. Then the evil people at Pepsi infiltrate Coke and poison the syrup.  People are now dying of Coke. What is your Coke stock worth? $0. This is called company risk.  We want to diversify away from company risk such as Enron, Global Crossing and many other bad companies in good industries. This is where mutual funds enter the picture.

II.  Mutual Fund

Investing in a mutual fund is pooling investor’s money together and hiring a fund manager to manage your money. In our cola example, let’s say that there are 50 cola companies in the US. The mutual fund does not know your personal objectives but does operate under a published objective. A mutual fund objective could be to invest in large cap US stocks or foreign bonds. In our example the fund manager is looking for the 20 best cola companies out of an industry of 50. This gives the investor diversification from company specific risk. The funds goal is to beat the index of 50 cola companies.

While very popular, mutual funds have drawbacks. Many of the mutual funds in the ASA 401k plan have over 100% in annual turn over. This means that the fund manager is buying and selling a lot through out the year. For every 100% in turnover we see an added 1.0 – 1.5% in fees. In our cola example, our fund manager would be buying and selling the cola stocks on a regular basis in an attempt to beat the cola index. This type of investing is considered “active” management.

III.  Index Fund

In today’s society we are programmed to think that we are all “winners.” In fact if you think that you are not a winner then you may be depressed and a doctor can proscribe you a pill for that. Applying this thinking to investing can create poor investing behavior. We see this in a study by the University of Maryland “False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas” showing that only 0.06% of mutual funds beat their assigned index from 1975 to 2007.  This draws us to our third choice of investing, indexing.

Through Index Mutual Funds or Exchange Traded Funds investors now have the ability to purchase entire asset classes (large, mid or small caps) or sectors (US energy, foreign, real estate, etc.). In our example we could purchase the entire cola index through an index mutual fund or exchange traded fund. Index funds do not have fund managers as the fund is simply purchasing companies chosen by the index provider such as S&P or Russell. This type of investing is considered “passive” investing

A real world example of indexing would be purchasing the entire S&P 500 (500 US companies) through an index versus buying the JP Morgan Large Cap fund that only holds 68 companies. The JP Morgan Large Cap Fund has an expense ratio of 0.80%. The Vanguard S&P 500 Index Fund costs 0.05%.  This cost savings adds up to significantly more money in the plan participants’ pocket at retirement. In this comparison the performance difference over the last 10 years is in the favor of the index fund. History and research show that for time periods greater than ten years, indexing continues to be favored.

Currently the ASA JP Morgan 401k plan has one Index fund – the JP Morgan Equity Index Select. It should be noted that in time periods under ten years, we could usually find good performing actively managed mutual funds. However, most of you are saving for time periods greater than 10 years. For you, keeping costs low, maintaining diversification and investing long term are your keys to success.

The current line-up of ASA Mutual Funds are some of the best performing actively managed funds to choose from. However, during our research we found that a low cost index portfolio using Vanguard index mutual funds is very competitive, especially with the cost savings.

Wiser Wealth recently researched 401k options that could be available to ASA and Express Jet employees. We found that switching 401k plan providers entirely should be considered as JP Morgan provides very poor guidance to ASA plan participants. However after the recent changes with JP Morgan, Sky West/ ASA seems committed to JP Morgan. This leads us to a less known option.

Vanguard Indexing Within the JP Morgan 401k Plan

ASA/Express Jet has the ability to add an “index tier” to the ASA JP Morgan 401k Plan. This simply means that in addition to the current line up of mutual funds plan participants would also be able to choose index funds representing cash, US Bonds, US large caps, US mid caps, US small caps, international developed markets and international emerging markets.

The benefit of an index tier is that it gives 401k participants (you) access to industry leading index funds, low cost investing, plan reduction of active manager risk and historically better performance. The company benefits, as well, in that offering index funds within a plan reduces their litigation risk. A recent court case suggests that having index funds within the plan lower the litigation risk for all plan fiduciaries.

Mike Lucci of Vanguard states,

In closing, Wiser Wealth likes it anytime a plan sponsor (ASA/Express jet) lowers the cost of investing. The recent changes by the company were done with your best interests in mind. We hope that they would consider the benefits of adding indexing to the 401k plan. With a combined $400 million in 401k assets, government encouragement and a fiduciary responsibility to work in the best interest of all plan participants, there is certainly no reasonable rational reason anyone could say no.

See PDF version for more information on adding Vanguard to the JPM Plan.

CLICK HERE FOR MORE JP MORGAN 401k GUIDANCE 

There was a man who considered himself to be a very conservative investor.  He said he could not handle any losses in his accounts.  He asked his newly acquired financial advisor to take a look at his 401(k) account, to which he had been contributing for over 20 years.  His employer used a major 401(k) provider, who offered hundreds of fund choices with the plan.

His financial advisor took a look.  And was shocked.  And well, was not shocked at the same time.  This man was 100 percent invested in company stock.  This is about the riskiest investment you can have in a 401(k) plan.

This man was a US citizen who had immigrated to this country many years back.  With a native tongue that was not English, he was sometimes confused when discussing the more technical aspects of financial dealings.  So he relied more heavily on the opinion of those people who portrayed themselves as experts.  Before his recent foray into using a financial advisor, he essentially used the advice of his employer, the plan sponsor, by accepting the default investment.  In this case, the default was company stock.

Plan sponsors can’t do this anymore – use company stock as the default investment when their plan participants don’t choose their own investments.  This was one benefit of recent disasters where participants lost their life savings when the value of their company’s stock plummeted to zero.  The trend now is to use a life cycle fund as the default, or a very conservative investment.  But this trend change was too late for this man’s original investment choice.

He was fortunate in that he worked for a stable, growing company, whose stock value had increased significantly over time.  However, besides the lack of diversification, this man had one year to go before retirement.  Very aggressive investments were inappropriate on both counts.   Obviously, his financial advisor quickly had him move to much safer investments.

You’d think he’d be happy now, right?  Turns out he liked the rapid growth of his retirement account.  He rather grudgingly accepted the wisdom that conservative investing was appropriate for his life stage and risk tolerance, not liking the reduced rate of return.  But he still had no framework for risk of loss.  Attracted to and overconfident in strong growth (and outside of the advice of his financial advisor) he invested $5000 of other money in the initial public offering of his son’s company.

The IPO opened at $50 per share.  Within a day or two, the value had risen to $52 per share.  After the initial excitement, however, the value settled down to around $49 per share, where it has been holding steady.  At 100 shares, he is now sitting on a book loss of about $100.

Has he complained?  Oh, yes!  Yes, he has.  You see, he is indeed a very conservative investor, having conniptions over an unrealized book loss of 2 percent.  Even though he doesn’t need his investment back, he now wants to sell immediately, not trusting the value to rise up again.

So why the flip flop?  In a word, greed.

Risk vs. Reward

There is no room for greed in investing.  In the investing world you can’t have your cake and eat it, too.  If you want the reward you have to take on the risk as well.  Put another way, you have the potential to be rewarded for the amount of risk that you take.  Notice I said “potential”.  Reward is not a guarantee.  The reason is risk.

To illustrate, let’s look at a savings account.  The interest on savings accounts nowadays is so low it might as well be non-existent.  Your deposits are also federally insured, so there is little risk of loss.  So a savings account would be a baseline investment, illustrated by a flat level line.

Let’s step up the risk.  An investment-grade bond has the potential for higher return than a savings account, but also the potential for higher loss.  The swing can be measured as going above and below the baseline.  For an investment grade bond, the swing will be fairly narrow.

A high yield bond offers the potential for a higher return than for an investment grade bond, and also a higher potential loss.  So the swing on a high yield bond would be wider.  A stock offers an even wider swing than that, with greater potential for both gain and loss.

In short, you have a diagram that looks like this:

The farther out you go in risk, the greater the potential for gain or loss.

I think you’ll agree you’re like most people.  Looking at reward only, you want the biggest reward you can get.  Who wouldn’t?  The question then becomes, how much are you willing to lose?

Ah.  That is the crux of the matter.  It’s the reason why risk tolerance questionnaires focus on how you would react to a downturn in the market, instead of focusing on your reaction to an upturn.  Because this is where your true colors come out – when you are facing the loss of something precious to you.

Investors who have trouble contemplating potential losses should not be aggressively invested, no matter how much they desire big returns.  Investors who are comfortable taking on risk, and who have the capacity to withstand a large loss should it come about, would be fine investing aggressively.

The problem comes in when investors don’t fully understand or appreciate risk.  Take the man in my tale.  In not paying attention to his 401(k), he missed the impact of the ups and downs of his company stock’s market price over time.   He just saw that he started with nothing, put a little money in each paycheck, and ended up with a large chunk of change.  It wasn’t until he invested in the IPO and watched the price go up and down, and saw the impact on his invested principal, that he fully comprehended this thing called risk.  Now he knows for sure that he’s a conservative investor.  And he has stopped squawking about the conservative returns on his 401(k).

His financial advisor celebrated with a slice of pie.

At what age is it better to save for retirement?  In your early years of working, money is probably tight.  It’s hard to find the extra money to save towards such a far end goal, when the rent needs to be paid, and you have a more immediate need to build emergency savings.  You might think that waiting until later in life to save for retirement, when your income is likely higher and you can more likely afford to do so, would be the best option.

Or maybe not.

Take Frankie and Johnny.  Both are age 20 and have decent jobs.  Frankie and Johnny want to have money for retirement, but take two different savings tracks.  Frankie wants to save now, when she has fewer expenses; she anticipates she may have to stop saving as expenses rise.    Even though he has a good job, Johnny thinks his current expenses are too high to justify saving right now; he wants to wait until he can get his income up before saving.

Both anticipate they will save $200 per month, and estimate they will earn 6% on their investments, compounded monthly.  They both plan on retiring at age 65.  The only difference is the point in time when Frankie stops saving and Johnny starts.

The 5-Year Plan

In this plan, Frankie contributes for five years, then stops.  Johnny starts saving after five years, and saves for the next 40.

Frankie contributes at total of $12,000 over the five-year period.  At age 65, she has a retirement balance of $153,665.  Johnny, in contrast, contributes $96,000 and ends up with $400,290.  Johnny contributes in total eight times what Frankie contributes, and realizes 2.6 times Frankie’s results.  Still, $400,290 is more comforting than $153,665.  To match Johnny’s results, Frankie would have needed to contribute $5,708 per month for the first five years; that’s 28.5 times the original $200 per month.

The 10-Year Plan

In this scenario, the pivot point is 10 years. Frankie contributes a total of $24,000 over that 10 year period, while Johnny goes on to contribute $84,000 over the course of 35 years.  At retirement, Frankie has a balance of $267,588.  Johnny has a balance of $286,367.  Johnny contributes in total 3.5 times what Frankie contributes, for only 7% more in his retirement account.  To match what Johnny ends up with, Frankie would have needed to save only 7% more, or $214.04 per month.

The 15-Year Plan

Let’s take this out to 15 years.  Frankie saves a total of $36,000 and ends up with $352,047 at retirement.  Johnny contributes $72,000 and has $201,908 at retirement.  Johnny contributes twice as much as Frankie (in twice as many years), but ends up with 42.6% less.  To match Frankie’s gross balance of $352,047, Johnny would have needed to save 75% more, or $348.72 per month.

A Split Pivot Point

Let’s throw one more scenario into the mix.  Let’s go back to the five-year plan, where Johnny ends up with so much more money than Frankie.  This time around, let’s have Frankie save for 20 years, starting at age 20.  Johnny still waits five years, but then contributes for the next 40.  In this case, Frankie ends up with $414,663, compared with Johnny’s $400,290.  But Frankie only needs to save half as much as Johnny to end up with nearly the same results.

So what does this all mean?

The key point is that the longer you wait, the more you pay, the longer you pay, and sometimes the less you end up with.  This is the time value of money.

It is better to live leanly in early adulthood, even though you typically have less income, because you also typically have fewer obligations and perhaps are more used to being “thrifty”.  Later, when income has risen, so generally have your expenses, and it’s hard to cut your lifestyle down at that point.  Saving early gives you a worthwhile discipline that will always serve you well.

If you have put things off, don’t stress; it’s not too late to put a plan into action.  Just know that you will need to pay more for the privilege.   What is important is to not put it off any longer.  Don’t let time pass your money by.

See the flyer for more details.

There are three ways to invest:  buy stock, purchase a mutual fund or invest in an index fund. Purchasing individual stock has its risks and rewards. Often, retail investors think about the successes of Google and Apple, or happily recall the 80s and 90s victories of Coke and others. Unfortunately, it’s easy to forget about stock blowups like Enron, GM and BP, which are examples of company risk. Since the 1980s, mutual funds have served as a great diversifier for individual investors by giving them access to professional money management. However, over the last decade, many of the best fund managers have left the mutual fund business to work in the less regulated hedge fund world. The loss of talent, volatile investment climate, under performance and ethical missteps have brought a lot of unsavory attention to mutual funds recently, putting more focus on a third investment option, indexing.

Indexing visionary John Bogle, founder of Vanguard, brought the first index mutual fund to market. The concept is that over the long term, an active portfolio manager’s rate of return moves back to the average (the index; S&P500). We see this in a University of Maryland study that shows that only .06% of managers beat their assigned index from 1975 – 2007 after fees. Over shorter periods of time, active management improves its record with 33% beating the assigned index, according to Morningstar. This is the same concept that compelled the great investor Warren Buffet to bet hedge fund managers $1 million that they could not beat the S&P 500 over a ten year period. He had also offered investment advice to individuals, stating that most individual investors should consider index funds for long term investments.

The concept behind indexing is to purchase everything within an asset class. For example, if you want to hold domestic large cap stock, you can purchase a Vanguard S&P 500 index fund that holds all 500 S&P companies. This works in opposition to a mutual fund manager selecting 30 to 100 funds and having 100% turnover in annual portfolio holdings. The same system applies to the S&P 600, 400 and International indexes. The indexing approach virtually eliminates company risk, as well as active management risk.

In 1993, the first Exchange Traded Fund, named the Spyder, was created. Today, it still represents the S&P 500. An ETF is very similar to an index mutual fund, but with added benefits. An ETF trades similarly to a stock in that you can trade during market hours rather than waiting for the close of business like a mutual fund. The structure of an ETF allows the fund administrator to rebalance the fund without passing through any capital gains to investors. Because there is no active management involved, the cost of ownership is very inexpensive. The S&P 500 ETF costs 0.09% a year in fees. This is much less than the average 2.2% that a mutual fund costs. An ETF is also very transparent, allowing investors to see the fund’s holdings in real time versus just quarterly with mutual funds. There are currently over 900 ETFs on the market with over $1 trillion in assets. In the last three years, more money has flowed into ETFs than mutual funds. TD Ameritrade says that 80% of portfolio managers, active and passive, use ETFs in some fashion. Charles Schwab says that 15% of retail investors are using this relatively young product. We also see innovative companies such as Fed Ex and Apple now building 401k portfolios entirely with index funds and in Apple’s case, ETFs.

FIDUCIARY

A plan sponsor has the fiduciary responsibility to act solely in the interest of plan participants and their beneficiaries with the exclusive purpose of providing benefits to them. This means carrying out their duties prudently, following the plan documents (unless inconsistent with ERISA), diversifying plan investments and paying only reasonable plan expenses. Adding Exchange Traded Funds to a brokerage link allows the participant to diversify away from active management risk and specific company risk. The ETFs will bring substantially lower investing fees to the plan versus what is currently being offered. Fiduciary duty demands that ETFs and/or index mutual funds be considered in any 401k plan.

COST

The graph below compares the cost of a moderate risk portfolio using the current JP Morgan 401k plan options versus a moderate risk ETF portfolio that could be held within the brokerage link. The difference is 0.61% a year, which would add 11% to a participant’s 401k balance assuming he or she is adding $8K a year to the plan for 30 years. That provides an additional $59K in value to the participant. The two portfolios had essentially the same performance over similar time periods. Low Cost was the contributing factor to the increased rate of return.

ETF DIVERSIFICATION

Many ask why it is a good idea to choose ETFs over Index Mutual Funds. Inside a 401K, it is difficult to compete with Vanguard Index Mutual Funds as a built-in investment option. We would think this is one reason why Fed Ex and other large companies have chosen Vanguard as their 401k custodian and administrator. Otherwise, ETFs inside a brokerage link are a great option compared to expensive plan mutual funds. Essentially, the creation of Index Mutual Funds was the stepping stone to ETFs. ETFs provide low cost index access to areas that many 401k mutual funds do not cover, such as small cap developed international, frontier markets, commodities, emerging markets, Treasury Inflation Protected Bonds, Emerging Market Bonds and various durations of treasury and corporate bonds. ETFs also cover all traditional asset classes much less expensively than traditional index mutual funds and 401k plan options.

CAUTION

Wiser Wealth Management is a leader in the usage of ETFs, as well as developing and disseminating ETF education worldwide. We have spoken in Europe, Asia and the United States about the benefits of using ETFs within portfolios. However, some ETFs are not for retail investors. The Pro Shares product line of inverse funds are for day trading only and in our opinion should never be an option for a plan participant. Other ETFs should be limited based on their low trading volume and low assets under management. We would also recommend that the plan sponsor request a best execution strategy for trading stock and ETFs within the brokerage link to prevent JPM from marking up trades. Additionally, we would recommend that education be provided to all plan participants about the benefits of a brokerage link, as well as the risk (in plain language) just as ALPA is doing with its pilots.

CONCLUSION

In “A Father’s Book of Wisdom,” H. Jackson Brown wrote “ignorance is to reject something that you know nothing about.” Financial advisors, individuals, the media and professors are all still learning about the benefits of Exchange Traded Funds. Undoubtedly, ETFs have shaken the investment world by empowering investors at all levels with quick access to low cost diversification. Adding ETFs to the Atlantic Southeast 401k brokerage link will allow investors low cost access to global asset classes. If used properly, ETFs can increase the standard of living of the Atlantic Southeast retirees and allow for current reduced company risk, active management risk and portfolio liquidity. ETFs will allow plan participants to purchase the indexes that the active managers cannot seem to beat over long periods of time.

Casey T Smith

President

Wiser Wealth Management, Inc

www.wiserinvestor.com

ASA ALPA 401k Specialist

Standard deviation measures the risk of an investment. For example, the Growth Fund of America has a 5 year standard deviation of 16.45 and a 5-year average annual return of 4.76. This means that the portfolio historically has moved 16.45% above 4.76 and 16.45% below 4.76 over a 5 year period. This gives you an idea of your downside risk and upside potential. In comparison, the PIMCO bond fund has a 5 year standard deviation of 4.25 and a 5 year average return of 7.17. Adding these two funds to a portfolio at a 50/50 ratio would give the portfolio a 5 year standard deviation and rate of return of 10.35 and 5.96, respectively. In this scenario, we just lowered the risk of the overall sample portfolio by adding bonds. You can use Morningstar.com, a free and independent research firm, to find the standard deviation and rate of return of each fund within our 401k plan. As you will see, some funds in our 401k plan, while they may be in the same asset class, do not have the same risk.

By Kyle Waller, Research Analyst Wiser Wealth Management, Inc & Casey T Smith, ASA ALPA 401k Specialist

In 401K investing, there is a major asset class that does not get the respect it deserves. In fact, it is largely ignored both by investors and plan sponsors. This asset class, small cap stock funds, is a very important element in a 401K plan.

Throughout the history of the stock market, small cap stock funds have significantly outperformed their larger counterparts.  There are some reasons for this that make small cap funds a category that should not be overlooked in your plan. That being stated, the potential for excess long-term performance comes with some serious risks that should also not be overlooked because of downside risks and excess volatility.

The JPMorgan ASA employee 401K plan has three small cap funds. Two of those funds have a management strategy designed to invest in growth stocks, while one fund is designed to invest in value stocks. Below is the Morningstar Style box, which simply categorizes large, mid and small in rows, while placing the “styles,” (value, blend and growth) in columns. Style is something to consider when choosing funds, but size is more important to consider. Size tends to be a larger determinant of returns relative to style. However, most mutual funds have both size and style directives and both should be taken under consideration before choosing one.

Small Cap Stocks as Building Blocks

Building a solid portfolio can be done with many different strategies, but most professionals believe that having a diversified portfolio based on asset allocation is most appropriate. Asset allocation would mean that a portfolio would include diversified investments from different categories, and apply different weighting based on the investor’s individual risk tolerance and how risky each investment is. Most allocations are based on age or years to retirement.

The three small cap funds in the ASA employee 401K plan are the Buffalo Small Cap, Columbia Small Cap Value II Z and the LKCM Small Cap Equity Advisor. When reviewing these funds, it is important to study risk, cost and track record, among other factors. Cost takes away from return, and there are hidden costs to consider like turnover, which is the fund’s trading frequency. This is an important consideration, because these trades incur cost for the mutual fund. A random track record statistic alone should not be the deciding factor; it should be compared with benchmarks. For example, it would make sense to compare a small cap growth fund’s return with a small cap growth benchmark. There are several ways to look at a fund’s risk. One way is to simply look at its standard deviation, which is a measure of variability from the mean. The higher the standard deviation, the higher the risk is perceived to be. Often, standard deviation is just called risk, like you see in the scatter-plot below.

The Importance of Small

Below, we see the difference smaller companies can make. Over last 15 years, we see that small cap companies significantly outperformed the large cap S&P 500, despite underperformance during the tech bubble. Going back further would reveal that this pattern does exist over long periods of time.

So, what is the cause of this higher performance? Put simply, smaller companies tend to grow at a faster rate and, over time, larger companies still grow, but much more slowly. Smaller companies have less economies of scale, less complex capital structures, less debt and lean more on a competitive advantage, which can quickly change. What it all boils down to is that smaller companies are more risky and the investor is compensated for that risk in the long run. This works just the same way a bank demands a higher interest from a person with a lower credit score or a higher risk of default. The market demands that same kind of compensation.

Below is a scatter-plot showing the risk of each investment, plotted against the return. Notice that the small stock index has more risk, (being further to the right) but a higher return as compensation for that risk relative to the S&P 500.

Source: Morningstar

Small cap stocks should not be a centerpiece for a portfolio, but certainly a building block. There is a case for small cap stocks outperforming larger stocks, but we need to remember that larger stocks tend to be more stable, which is why investors, over the long run, are compensated less. Of course, over short periods of time, we could expect small cap stocks to be punished more by the market for not being stable. We could say that many smaller companies’ stock prices reflect the potential for growth or future cash flows while larger firms typically have more established assets, which generate cash flows more steadily.

In this way, a solid investment portfolio will include small cap stocks in relatively modest amounts, while core holdings will be built using larger stock funds and bond holdings.  Small cap stock funds are typically considered satellite holdings.

Building With Small Cap Funds

“Investing has and always been, and will remain, an operation in which wealth is transferred from those without a working knowledge of the financial history to those who have one.” William Bernstein

Knowing your history is the key to building a portfolio that will get you to retirement and into retirement. Small Cap stocks have a place in portfolios. They are riskier than other investments and therefore should be limited in even the most aggressive portfolio. Where your personal portfolio falls in the risk spectrum is up to you, but should be based on the reality of your situation and not an attitude or appetite for risk and speculation.

By Casey Smith, ASA ALPA R&I Committee 401k Specialist and

Kyle Waller, Research Analyst, Wiser Wealth Management, Inc

The saving rate among Americans is decreasing, yet the need for income in retirement is as crucial as ever with pensions and social security becoming scarce and not as guaranteed as they once were.

There is a real cost to not saving, and that cost increases as retirement approaches. This is a particular concern for us as pilots with forced retirement ages, since we will not be able to choose to continue working into our 70s.  That being said, there is still hope at any age and it is never too late to start getting out of debt and saving for future needs. No matter the state of the nation’s economy, focusing on your personal economy should come first.

As we can see above, the saving rate among Americans has been on a sharp downtrend since the late 1980s, dropping to record lows during 2008. Recently, it has risen to just under 4% on average in 2009 and this year.

Saving has risen again recently due to the lower availability of credit. Since credit is never a guarantee, Americans need to adjust their dependency on easy access to credit and put away a higher percentage of what they earn. In general, the upcoming generation of retirees is more accustomed to widely available credit and is more optimistic than previous ‘thriftier’ generations.

Financial Knowledge vs. Time

Financial wisdom is an important key to having a successful portfolio. However, the more valuable factor that is often overlooked is time. Time gives the investor the ability to make it through both economic downturns and market booms. Historically, the market has behaved with large gains or losses over short periods of time. The secret to financial success is having a good strategy and the time to see those investments through the long run. You can see the value of time and saving sooner rather than later in the scenario below.

How Much To Save

A good rule of thumb is for an individual to be able to withdraw 3-4% in retirement without touching principle. This would generate $40,000 annually from a $1,000,000 portfolio.

Source: Morningstar, Inc using a 7% interest rate

Life isn’t as simple as the illustrated example since a professional pilot will most likely receive significant pay increases throughout his or her career. Another thing to consider is that as retirement approaches, it makes more sense to alter the investment portfolio to become more conservative, taking less risk and avoiding major market swings. This is another reason a younger person saving for retirement is at an advantage; they can take an aggressive investing approach and see that strategy through bad market cycles to success.

The ASA matching schedule is given below:  A healthy amount to save each month is 15-20% of your income. The sooner retirement is for you, the higher this percentage should be. At the very least, an ASA employee should be putting 6% into his or her 401K account out of every paycheck. Not doing so is taking a voluntary pay decrease. If you’re not saving this much, stop reading, log onto your account and change the percentage to at least 6%.

The ASA matching program matches a portion of the first 6% of your contribution based on completed years as an employee. Therefore, a second year employee (one year completed) will be matched 1.2% if they put at least 6% away in their 401K account (20% of 6%), this is in contrast to a 5% contribution rate which would be matched 1% (20% of 5%). Therefore, the real cost of not saving at least 6% is 1.2% for a second year employee.  The incentive is increased as the employee completes more years.  The program is designed to make a monetary incentive for saving through the program.

Behavior and Success

When making a plan for saving, it is important to note that good saving and investment behavior is as important as anything else. Saving should become systematic and so should the way you invest. This means no matter what the stock market is doing, you should be putting the same amount into your 401K and investment accounts every month. You should begin to think the same way about investing as you think of your monthly mortgage, a required bill.

Long term investing success really depends on playing great defense, which is sticking to the plan. This involves patience and endurance through market crisis, which will always come and go. An investor with a great strategy and the time to see it through will be successful and profitable in the end.

Why is behavior important? There is a gap in the stock market return and the average investor return, coined the behavior gap (see www.behaviorgap.com).

This behavior gap is caused by investors reacting to the ups and downs of the stock market, and can be very significant. When an investor reacts to the stocks market, i.e. buying stocks when they are rising, that investor is buying high. In the same way, selling stocks when they are falling is selling low.  A profitable strategy is obviously just the opposite, selling high and buying low. To pull off this strategy successfully, a great amount market insight and forecasting is required. Even with good information, it is difficult do profitably over the long run. The better strategy is choosing funds to create a diversified portfolio and sticking to that plan no matter what happens in the market. This is a simplified version of a buy-and-hold strategy, but the “behavior gap” will be completely erased when an investor properly employs a no-nonsense buy and hold strategy.

In Conclusion

Investment and retirement savings success does not depend on financial knowledge or complex strategies. When you are saving for retirement, create a hands off plan for saving, get on board with that plan and see it through to retirement.

You can view more 401k articles, the pilot retirement calculator, 401k model portfolios and research at www.wiserinvestor.com/resources/asa

What does that have to do with you, a US investor? Over 50 percent of the the revenues of the S&P 500, the 500 largest companies in the US, come from overseas. Declining foreign sales and a declining euro hurt our mega corporations. You might be wondering what you should do with your 401k. If you are properly allocated according to your age and risk tolerance, the answer is nothing right now except possibly increasing your contribution to take advantage of the sale. You should also make sure that your portfolio is properly diversified. Is your 401k in all cash? Do you have more than 30% in any one fund?

The biggest risk to your retirement is not saving. The second biggest risk is how you invest. Print off a copy of this connection email as a reminder to look at your 401k allocation. You can also visit www.wiserinvestor.com/resources/asa for tips on allocating your portfolio. Of course, you may also call me anytime to discuss your individual situation.

Casey Smith ASA ALPA 401k Specialist