One of the simplest ways to maximize your the money you contribute each pay period is to allocate a portion of them to underperforming asset classes. Depending on your level of investment knowledge, that last statement may have read more like Pig Latin than investment advice, so let me break it down for you in simple terms and actions. Asset classes refer to investment categories such as large cap value, mid-cap growth, small-cap value, international, and emerging markets. The strategy suggests taking a portion of the money you contribute each pay period to the worst of the group.
This approach is based on a theory called the Dog’s of the Dow. Without boring you in academia, one of the assumptions in the theory suggests that companies and asset classes have a natural, repeating cycle in which good performance begets bad performance and vice-versa. Ideally, by investing some of your regular contributions into asset classes that are doing poorly, investors continually buy shares at a lower price with the goal of eventually riding the asset class back to the top. As a point of reference, there is something called the Callahan Periodic Table that lays out which asset classes were the best and worst for each year going back to 1992. As you can see, there is no discernible pattern and sometimes the worst performer can become one of the best.
Essentially, what investors can do is invest a portion of their regular contributions into the dogs of their retirement plan. The strategy works well inside 401(k)s and other retirement plans because of dollar cost averaging (DCA). The concept of DCA suggests that by investing a small amount of money each pay period into specific funds, over time, investors may get a better average price than they would if they just invested a lump sum of money all at once.
So let’s explore the fundamentals and applications. Emerging markets, particularly those heavily invested in China are down nearly double digits so far this year… and recent reports suggest they made still head lower. If you purchased 50 shares of a fund for $5 in pay period one you’d spend $250 for those 50 shares. In the next pay period, let’s assume the fund falls to $4. That same investment of $250 now provides an investor 62.5 shares, 12 more than the prior month. The next pay period, the fund tumbles again to $3 and now the same $250 nets an investor 83.3 shares. Over three pay periods, 195.83 have been acquired for $750. An average cost of less than $4. Hypothetically, let’s assume China and other emerging markets improve over the next 12 months and the fund jumps back to $5. That $750 investment is now worth $979.15. A handsome $229 gain or 30% return. (Important note: It may take longer than 12 months and the concept is for illustrative purposes only.)
Now that you know the basics, let’s address the tricky part for most investors, i.e., finding out which asset classes are performing the worst. Thankfully, there are services like Morningstar that can quickly provide investors with some idea of where to look for the underdogs in their 401(k).
Start by going to Morningstar.com and click the “Stocks” tab in the top menu. Next, scan through the column on the left for the “indexes” tab (or just click here). There you’ll find market performance for various asset classes such as large-mid-and small cap value along with similar growth categories. Bond performance categories are a little further down the page where you’ll also find foreign indices like the Shanghai composite (china / emerging market) which was trading at (-8.8%) year-to-date (YTD). Remember to be patient and diligent as you digest the list and all the details it includes. Consider focusing on the YTD performance category as an initial reference point to identify underperforming asset classes for now. Investors can also use the performance categories offered by their plan provider to see which area are doing the best and worst. A note of caution: In current market conditions, this strategy is best applied to equity or stock related asset classes and not bonds or fixed income. As you will see, most bond funds are underperforming equity or stock funds because of low interest rates… and since bond fund returns can be directly impacted by increasing interest rates, this strategy may not be as impactful for them.
Now more than ever, investors need to develop investment strategies that help them get the most out of their 401(k). By taking the time to identify and invest a portion of their regular contributions into underperforming asset classes, investors can use a strategy normally reserved for more knowledgeable and experienced market players to their company retirement plan.
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