When good intentions backfire

June 01, 2008|By Gail MarksJarvis | Gail MarksJarvis,Your Money

Pat Carter is within weeks of retiring and is coming face-to-face with the financial struggle she will encounter for the rest of her life and the risks she inadvertently took that threw her into the predicament.

In 2000, she was about eight years from retiring, and trying to set herself up for the future. But her good intentions backfired.

With $2,000, she opened a Roth individual retirement account and followed a broker's suggestion - putting the full $2,000 into a high-risk, aggressive stock mutual fund. It didn't seem risky at the time. She had been told that Roth IRAs were smart to have and a broker picked the fund.

But within weeks of making her investment in the Putnam Discovery fund, the stock market began to crash and stock funds like the one Carter's broker selected sank more than most. Carter didn't understand stocks or know why she was losing money, but as she watched her money evaporate, she concluded that Roth IRAs were dangerous, and she never invested in her Roth again. She sent me an e-mail recently to warn others to avoid the mistake she made.

Now, her original $2,000 investment is worth about $1,040, and at age 66 she has just $55,000 saved for retirement.

She is learning, as many do when retirement creeps up on them, that risk is a tricky concept. She avoided investing in her Roth IRA, thinking it was risky. But, in fact, the real risk she will face in the future is the absence of money. And she could have cut that risk if she had used her Roth IRA more fully and kept contributing.

Her actions are predictable, said Christopher Jones, chief investment officer of Financial Engines and author of The Intelligent Portfolio: Practical Wisdom on Personal Investing from Financial Engines.

Most people do not know how to invest money. Financial Engines, which provides advice for 401(k) investors, says only about 10 percent to 20 percent of people are investing their retirement savings correctly. Fidelity puts the number handling 401(k)'s competently at about 30 percent.

Handling a 401(k) or IRA well means investing in a variety of stock funds and bond funds, so the mixture helps people grow money, rather than losing it abruptly like Carter did.

For example, Chicago financial planner Jeff Kostin said a conservative person with 10 years to go until retirement might put about 50 percent of her retirement savings into a bond fund, which is a safer choice than a stock mutual fund. To make the money grow moderately, without the risks Carter took on, the rest would go into a blend of stock funds.

The variety: 25 percent in a fund that invests in large U.S. stocks, known as a large-cap stock fund; 10 percent in a fund that invests in smaller companies, a small-cap stock fund; 10 percent in a foreign fund that invests in stocks around the world, and 5 percent in a fund that invests in real estate investment trusts, known as REITs.

If Carter had done this, her original $2,000 would be worth close to $3,000 now rather than $1,000. If she had contributed the maximum into her Roth IRA each year, she could have roughly twice as much money as she has now.

Americans could avoid many of the mistakes they make if they realized how to combine types of mutual funds, and recognized the difference between real risks and perceived risks, Jones said.

Psychology also works against people, said Terrence Odean, a University of California, Berkeley finance professor who does research in behavioral finance, or the psychology behind investing decisions.

A common problem, he said, is "uncertainty aversion." Faced with decisions they don't understand "people throw their hands up in the air" or they blame the wrong problem.

After Carter lost money, she had to ask herself: "Was it a problem with the broker, a problem with the fund, or a problem with the Roth IRA?" Odean said. "The problem was the broker and the fund. It clearly wasn't the Roth IRA," which provides an efficient way to save without having to pay taxes when the money is withdrawn. But the Roth is where Carter landed the blame, and to avoid feeling badly about losing money, she moved away from something that was good for her.

People who are close to retirement are the most vulnerable if they throw up their hands, said William Bengen, an El Cajon, Calif., financial planner.

But people of all ages are subjecting themselves to the risk of running out of money if they are not investing enough early in life or if they misunderstand risks and avoid stocks - the type of investments people need to maketheir money grow.

Bengen said people in their 20s and 30s can be entirely invested in stock mutual funds, regardless of market conditions. And people in their early 40s can be 80 percent invested in stocks.

gmarksjarvis@tribune.com.

Gail MarksJarvis writes for Your Money.

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