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How to outsmart the stock market

By Barbara Whelehan ·
Friday, October 18, 2013
Posted: 4 pm ET

This week, The Wall Street Journal ran an advice column addressing the concerns of a reader who must take required minimum distributions from her retirement accounts this year. Should she sell her winning funds or her losers, she wondered.

The short answer: She should sell her winners because then she would be "selling high," according to the article.

It's the holy grail of investing: Buy low, sell high.

Advice for savers

Investors who are still in the accumulation phase of retirement planning would do well to heed the "buy low" part of that advice. Apparently, it's tough to do, judging from the behavior of people with access to defined contribution, or DC, plans, such as a 401(k) or 403(b).

A recent study by researchers at the University of Missouri examined deferral rates among plan participants at three points in recent history, using data from the 2004, 2007 and 2010 Survey of Consumer Finances, or SCF. That triennial survey is a treasure trove of data.

The researchers wanted to see if plan participants contributed more to their plans when stock prices were on sale, as rational people would do. Consumers don't go to Macy's and pay full price if they can wait a week or two for a big sale and get 40 percent off, right?

The results were unsettling because rather than take advantage of the fire sale on stocks, plan participants recoiled from the markets, contributing less than they did when markets were performing relatively well -- i.e., when stock prices were higher.

The researchers examined how much participants deferred as a percentage of the maximum amount allowed by the Internal Revenue Service. For instance, in 2010, plan participants were allowed to contribute up to $16,500 in a DC plan, and those 50 and older, an additional $5,500 in catch-up contributions. So if someone age 30 contributed less than 20 percent, he would have deferred less than $3,300 that year. The table below shows the levels of contributions in each of the three years studied.

Deferral rates of plan participants in defined contribution plans

Amount deferred* 2004 2007 2010
< 20% 43.1% 51.0% 90.7%
20% - 40% 25.7% 23.1% 1.9%
100% 7.2% 7.5% 2.9%

*as a percentage of the maximum amount allowed by the IRS.

Source: "Determinants of Defined Contribution Plan Deferral," a study by Rui Yao, Jie Ying and Lada Micheas at the University of Missouri.

Recall that in October 2007, the stock market began its inexorable slide, hitting bottom in March 2009. So the 2010 SCF would have reflected investor sentiment in the aftermath of the financial crisis. It appears to have captured fear in investors' hearts. Investors contributed much less in 2010 than they had in previous years. Instead, they could have contributed the same amount or more, which ultimately would have helped them to better prepare for retirement.

The study controlled for employment status and income, so it looked strictly at deferral behavior. "If people did not lose their job and did not have a sudden increase in consumption needs, they should not have reduced or refrained from DC contributions," says Rui Yao, Ph.D., an associate professor in the department of Personal Financial Planning at the University of Missouri and lead author of the study.

After suffering two devastating bear markets over the past 13 years, it's easy to understand why investors don't trust the stock market. But historical returns show that, yes, the market tanks from time to time, but it eventually recovers. Those who invest in the face of adversity win in the end.

Should investors ever completely lose faith in the stock market?

"Empirical evidence indicates that at no point should investors lose total confidence in the stock market," says Yao.

There will be no permanent crashes unless the government takes over the ownership of businesses, she says, "which happened in some countries, but I am reasonably confident that this will not happen in the United States."

How will you react when the stock market crashes again?


Follow me on Twitter: @BWhelehan.

Barbara Whelehan is a co-author of "Future Millionaires' Guidebook," an e-book by Bankrate editors and reporters. It is available at Amazon, Barnes & Noble, iBookstore and other e-book retailers.

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October 19, 2013 at 12:07 pm

There will be no permanent crashes unless the government takes over the ownership of businesses, she says, "which happened in some countries, but I am reasonably confident that this will not happen in the United States."