Why Americans won’t day-trade their 401(k)s

By Felix Salmon
July 9, 2012
Walter Hamilton of the LAT has a big trend story today; since I'm in California last week, I can tell you that it even made the front page of the paper.

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Walter Hamilton of the LAT has a big trend story today; since I’m in California last week, I can tell you that it even made the front page of the paper. Here’s the thesis:

Americans worried about running out of money in their golden years are trying a new investment strategy: day trading their retirement funds.

Hamilton’s certainly found a few of these people. The most striking is Vlad Tokarev, a biomedical software engineer from Minneapolis with three different retirement accounts. “He is careful not to take excessive risks,” he says, since “he trades only one-third of his retirement savings.” Tokarev is also known as Vlad T on Amazon, where he asked some detailed questions of Richard Schmitt, who’s published a whole book, entitled “401(k) Day Trading: The Art of Cashing in on a Shaky Market in Minutes a Day”. Eventually, Vlad left a glowing review of the book, and seems to be following its prescriptions very closely.

But Hamilton gives very little evidence that this is a real trend at all. He mentions the guy with the book, of course, and also the guy with the website. (The book is $50; the website charges $200.) Other than that, there’s the guy who reviewed the book on Amazon, and then there’s one other person.

Joe Hansman, 29, who handles customer complaints at Wells Fargo, shifts money among two conservative mutual funds in his 401(k) and the banking company’s own stock. He trades 10 to 15 times a month, steering money into Wells Fargo’s stock when he expects it to rally for a few days.

This of course confirms everything you suspected about the kind of people who answer the customer-complaints line at Wells Fargo. Hansman really is day-trading Wells Fargo stock, buying before he thinks it’s going to rise, and then selling before he thinks it’s going to fall. The chances of this working out for him are pretty much exactly zero, despite (or perhaps because of) the fact that Hansman thinks he has some kind of inside track on what’s going on at Wells Fargo from answering the phones in its call center.

In reality, the last stock you should ever own in a 401(k) plan is your employer’s stock — you’re far too exposed to that employer already, and the whole point of having control of your own funds is to allow yourself to diversify. But this obvious fact, underscored by the Enron debacle, seems to be curiously lost on the good employees of Morgan Stanley:

Current and former Morgan Stanley employees, who receive company shares to match their 401(k) contributions, held 24 percent of retirement assets in the firm’s stock before last year’s decline, the highest percentage of any of the banks. They lost $570 million in 2011 as the shares plunged 44 percent…

The bank gives employees $1 of its stock for every $1 put into a 401(k) plan, with a limit of $9,800 a year. Once they receive the shares, employees are free to move the funds into investments other than the stock.

This actually gives me grounds for hope. Morgan Stanley employees, who can be assumed to be reasonably sophisticated about matters financial, turn out to be just as path-dependent as anybody else. Put them into something, and they’ll just stay there, no matter how obvious it is that they should move into something more sensible.

As a result, I suspect that day-trading retirement funds is extremely unlikely to actually become a Thing. People just don’t have the time or the self-discipline to do something like that — especially once you find out what’s involved. Because most 401(k) plans deliberately make it very difficult to do this kind of thing, these plans can only really be put into effect if you have two or even three accounts to trade. And if this kind of activity catches on, chances are the fund administrators will put an end to even the existing loopholes. These accounts are designed for buy-and-hold retirement funds, not for trading.

Lauren Young, in a peculiarly gushing video, says that we shouldn’t think of this as day trading, “but as a smart way to rebalance your portfolio”. That just doesn’t make sense to me. Opinions differ on what the optimal frequency is, when it comes to rebalancing: should you do it every six months? Every year? Only when you’re more than 5% or 10% out of whack? One thing I know for sure is that nobody advocates rebalancing on a daily basis.

And there’s a good reason for that. The strategy being advocated by Schmitt basically only works in highly volatile sideways markets, when up days are followed by down days and vice-versa. But the fact is that everybody who’s made real money in the stock market has done so by buying stocks and just holding onto them over the long term, as they steadily rise in value. Sometimes, stocks don’t do that; sometimes they move sideways for years at a stretch. But the point about retirement funds is that they’re designed for the long term — for patient investors who can afford to wait until the market rises. Whereas, with this strategy, the first thing you do when the market starts to rise is that you start selling.

Which brings me to the most profound problem with all these strategies. Because you can’t short stocks in a retirement account, all of these strategies involve moving back and forth, as frequently as once a day, between broad stock funds, on the one hand, and money-market or cash funds, on the other. As a result, over time, you’re going to find your retirement account much more invested in cash than it should be. A retirement account is no place for cash.

The phrase “day trading” brings to mind large losses on high-risk strategies. And it’s actually not that easy to engineer big losses if all you do is switch back and forth between a stock fund and cash: you have to try quite hard to buy high and sell low. What you will be doing, however, is ensuring that you’re less than fully invested in the kind of securities you ideally want to own over the long term. And the opportunity cost of that underweight allocation, when compounded over a decade or more, can add up to be something enormous.

The psychology behind day-trading 401(k) funds is not hard to understand. People want a decent amount of money when they retire, they don’t have that much money now, and they’re quite right to suspect that if they just keep their money invested in the S&P 500, then they’re very unlikely to end up where they want to be. So they decide that they’re going to try to take matters into their own hands. David Denby wrote a whole book about this kind of thinking; he called it American Sucker.

But the good news is that we learned, collectively, from the dot-com crash and from the 2008 crisis. Many fewer people, today, believe that they can turn the stock market into some kind of get-rich-quick scheme. And given the enormous obstacles involved in trying to day-trade retirement funds, I’m reasonably confident that 99% of their participants — including Lauren Young — will never even attempt it.

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