Examining Your Gift Horse  

The fastest way to reduce risk in your 401(k) account is to sell the shares of your employer.

            This is an uncomfortable truth. Nearly 80 percent of all 401(k) plans match employee contributions in cash. The other 20 percent do it in company shares. Whether the company stock is a “good” stock (it goes up) or a “bad” stock (it goes down) it’s mere presence adds a gigantic helping of risk.

            To understand risky we need to take a quick lesson in statistics. 

Standard deviation is a measure used by analysts to determine how much something fluctuates. The S&P 500 Index has a standard deviation of 19.6 percent. This means that it will provide its long-term average return, about 11 percent, in any year plus or minus 19.6 percent. It will do this two-thirds of the time.

So it will return somewhere between 30.6 percent and minus 8.6 percent in most years. The return will be greater, or smaller, the remaining one third of the time.

            The greater the standard deviation of an asset, the greater our risk.

            Got that?

            Now let’s compare some common standard deviations. The S&P 500 Index has a standard deviation of 19.6 percent.  The average individual stock in the index has a standard deviation of 65.0 percent. The average domestic stock that isn’t in the index has a standard deviation of 111.0 percent. The table below shows a rank ordered list of common investments and some well-known individual stocks.

Investment Risk, from 0 to 100 plus

Source: Morningstar Principia, Feb 28 data

            A little company stock in your 401(k) account can, as pointed out in my Sunday column, increase your risk a great deal.

 This isn’t all bad— in some cases the additional risk will bring additional return. We can adjust for risk using a measure created by a father and daughter team of economists, Leah and Franco Modigliani. The measure adds riskless cash to an asset until the joint portfolio risk matches a standard such as the S&P 500 index.

            For example, the average stock in the S&P 500 index has a standard deviation of 65 percent. Because the volatility is so high, it would take a mixture of 30 percent company stock, 70 percent riskless cash to have the same risk as the S&P 500 index. Over the 5 years ending February 28, that portfolio would have provided an annualized return of 8.69 percent, well behind the 15.9 percent return of the S&P 500 index during the same period.

            In other words, the risk adjusted return of employer stock in a 401k plan is very likely to be well below the return on a broad index. The situation is still worse for the more volatile stocks outside the S&P 500 index. With an average standard deviation of 111 percent and a 5-year annualized return 1.11 return of percent, such company stock was likely to be a major drag on 401k plan results.

            How serious is this?

            Very.

            The use of a single stock in a 401(k) plan creates a level of risk that is virtually impossible to offset. For most plan participants, at most companies, it will result in a smaller retirement nest egg. If you are one of the fortunate workers who have an employer who provides both a pension plan and a 401(k) plan, company stock could be regarded as a flyer— something you do with a small portion of your overall retirement resources.

But if you are an employee whose retirement will be built on 401k assets alone, company stock spells trouble.           

This information is distributed for education purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.

Photo: Jennifer Murray

(c) Scott Burns, 2022