Can You Earn Better Returns Investing Outside Your 401(k)?
Ask Real Deal Retirement
I’m just starting my career and my 401(k) is invested in a diversified portfolio of stocks that tracks the overall stock market. I’m trying to decide whether to simply increase my contribution to my company plan or start investing outside my 401(k) so I can earn a higher return by focusing on specific sectors of the market, such as technology or health care. Which do you recommend?
Generally, I think you’re better off doing your retirement savings within your 401(k). You get lucrative tax benefits and employer matching funds in most cases, plus the automatic payroll deductions ensure that you actually end up saving for retirement rather than planning to but not getting around to it.
That said, there are situations where you might consider investing some of your money outside your plan.
Maybe the fees in your plan are so high or the investment choices so bad that it makes sense to allocate a portion of your savings to an IRA, whether a traditional deductible IRA or Roth IRA (assuming you qualify for either or both versions, which this IRA calculator can help you determine). Or perhaps the fees and choices are fine, but you want to diversify your eventual tax exposure in retirement by keeping at least some savings in a tax-free Roth account. If your 401(k) doesn’t offer that option, then you may want to fund a Roth IRA.
Then again, maybe you would just like to have some money (aside from three to six months’ worth of living expenses in an emergency fund) in a taxable investment account that you can use to buy a home, start a business or whatever without having to tap retirement accounts and worry about 401(k) and IRA withdrawal restrictions.
But none of these reasons seem to apply in your case. Rather, you apparently want to invest outside the confines of your 401(k) because you think you may be able to juice performance by making bets on specific industries or sectors. If that’s your motivation, my advice is simple: don’t do it.
I can understand the urge to spice up your investing strategy. Indexing, or tracking the market, can be boring. There’s none of the thrill of the chase or the excitement one experiences if a bet on a hot fund or ETF pays off.
But while picking winners is easy in retrospect, it’s much more difficult to predict tomorrow’s top performers in real time. If you doubt that, take a look at this chart showing the year-by-year returns of the Standard & Poor’s 11 industry sectors over the past 10 years.
Notice that no sector has been the top performer two years in a row. Not one. Nor, for that matter, has any sector topped the chart more than twice over this 10-year span. So if your strategy is to go with a sector that’s having a bang-up year in the hopes that it will reprise its chart-topping performance the next year, you’ll likely end up disappointed.
You may also notice that the two sectors you specifically mention—technology and health care—haven’t exactly been fixtures at the top of the chart. Indeed, health care was never the top-performing sector over this 10-year stretch (although it did rank second three times) and technology was Numero Uno just once, in 2009 (although as the first half of the year, it was on pace to grab the top spot this year).
Note as well how winners in one year can be laggards in other years. Take the energy sector. Although it was the top performer two years (2007 and 2016), it slipped to the bottom half of the rankings in five years and was the worst-performing sector two years (2014 and 2015).
My takeaways from perusing this chart: Past performance isn’t much of a gauge for predicting future performance. And given the way different sectors move up or down in the rankings, I don’t see how anyone can reliably know in advance which sectors will be tomorrow’s leaders or laggards. (By the way, there’s a similar chart that tracks the annual performance of various asset classes—large stocks, small stocks, value, growth, investment grade bonds, junk bonds, etc.—that shows comparable year-to-year variations over the past 20 years.)
Of course, I suppose you could say that rather than try to switch in and of sectors, you could pick one or two that you think have the best long-term prospects and stick with them for many years. And such an approach could generate superior gains, assuming you choose the right sectors. Over the past 10 years, health care and technology would have been excellent choices as both easily outperformed the broad market. This was hardly a free lunch, though, as they were also a lot more volatile than the market overall. What’s more it’s anyone’s guess whether they’ll be the top performers over the next decade or longer.
Besides, even if you’re smart (or lucky) enough to identify the sectors that turn out to excel in the long run, there’s still the question of whether you’ll actually stick with those sectors during their inevitable lean years. After all, if your aim is to boost returns by homing in on specific areas of the market, I’d think there would be a huge temptation to switch to whatever sector has been hot lately, especially if it’s dramatically outperforming any you currently own.
Bottom line: If you want to invest outside your 401(k) for the reasons I mentioned above, fine. Otherwise, I recommend you stick to a broadly diversified portfolio of stocks that tracks the entire market. (While you’re at it, I suggest you also consider investing at least a small portion of your 401(k) in bonds).
If you find, however, that you simply can’t resist the urge to go with your sector-picking approach, then try to keep your bets small. That way, if your bets backfire, at least the damage to your nest egg and your retirement prospects should be minimal.
Walter Updegrave is the editor of RealDealRetirement.com. If you have a question on retirement or investing that you would like Walter to answer online, send it to him at email@example.com. You can tweet Walter at @RealDealRetire.