Commentary

Big Brother Wants to Run Your 401(K)

This article orignally appeared on Creators.com on September 5, 2002.

Congress returned from the August break eager to meddle in our affairs, even telling us how to invest our own money. I recently discussed the legislature’s looming pension reform battle on a CNBC show hosted by Sen. Jon Corzine, D-N.J. The senator is pushing a bill that would ban holding more than 20 percent of your 401(k) savings in a single stock, ostensibly to protect folks from taking that sort of risk.

I mentioned that previous laws to prohibit risky choices ended up banning one of the most vital varieties of diversification — namely, the right to hedge against a bear market by shorting stocks. Shorting stocks is not a prudent long-term strategy, but it can work very well during tough times. More choices are better than fewer, and that includes the choice of how much risk you take with a single stock. Many “Microsoft Millionaires” would not be happy with a law that forced them to replace that stock with assorted others. And Corzine’s own fortune came from shares in one company, Goldman Sachs.

Diversification may be less risky, but less risk usually means less reward. Besides, complete diversification would require owning foreign stocks and bonds, commodities and more. We have no choice but to make investment choices, and ownership of your own retirement fund includes the right to make risky choices.

Overblown claims about diversification arose from studies showing that most mutual funds did not do as well as the S&P 500 index. The 1996 “Motley Fool Investment Guide” noted that 80 percent of 5,845 mutual funds had not done as well as the S&P 500 index over a five-year period. The authors concluded you would be better-off investing in an S&P 500 index fund than trying to pick mutual funds or picking stocks on the basis of analysts’ reports.

Actually, such studies were irrelevant. Most investors do not invest in the worst 80 percent of mutual funds, but in a few of the best funds. Besides, many funds that did not do as well as the S&P 500 during the bull market were explicitly designed to generate higher returns in bear markets, such as bear funds, balanced funds and gold funds.

Most of the largest mutual funds and brokerage houses have done much better than the S&P 500 index over the past five years. Lipper’s list of the largest funds includes 27, aside from two S&P 500 funds and one newcomer with a short record. Out of those 27 funds, 19 beat the S&P 500 with an average return of 5.3 percent per year over the past five years, compared with an S&P 500 return below 1.7 percent.

Wall Street analysts often beat the S&P 500 by wide margins. Zacks Research says the accumulated returns on the S&P 500 added up to 19.7 percent over the past five years. Yet stocks recommended by Bear Stearns earned 59.4 percent, and those recommended by Merrill Lynch earned 43.6 percent. Out of a dozen brokerage houses, eight trounced the S&P 500’s with an average gain of 30.9 percent.

The S&P 500 index is weighted by “market capitalization” (the number of shares times their price). That is why a small number of pricey stocks like Cisco and Intel made the index hard to beat during the bull market. Stocks that fall too much during each year were also removed from the index and replaced with stocks that rose. That made the index rise even faster during the bull market, but it also resulted in the index becoming more and more dominated by tech and telecom. To diversify by investing in “the market” has not been such successful advice that we now need to require it by law.

The good news is that discriminating investors have not been nearly as badly injured as is suggested by calling the S&P500 “the market.” Because most big mutual funds have outperformed that index, and because the value of bonds and housing are way up, most American households are wealthier than gloomy journalists imagine. If Congress had left us more freedom to invest our savings the way we see fit, including hedging with shorts, we would be even better off.

If pension reform gives individuals more choices over how to invest their own money, then it might deserve to be called a reform. If it leaves individuals with fewer choices, it will just be arrogant meddling.

Alan Reynolds is a senior fellow with the Cato Institute.