How to avoid a retirement savings disaster

The US$140 billion ($195 billion) drop in the value of General Electric's stock price during the past year gets the full human interest treatment in the Wall Street Journal. I don't want to minimise the deep individual suffering of those who had their retirement savings tied up in GE stock, but it is as good a time as any to examine a host of human failings. My hope is to help others avoid a similar fate.

The Journal sums up the scope of the problem this way:

"The stock value lost by GE in the past 12 months is twice the amount that vanished when Enron Corp collapsed in 2001- and more than the combined market capitalisation erased by the bankruptcies of Lehman Brothers and General Motors during the financial crisis. Longer term, GE's market capitalisation has fallen more than $460 billion since its 2000 peak."

This sort of thing has happened many times, as that paragraph indicates, and it will surely happen again. Several forces keep driving these errors. Recognising and understanding them is crucial:

Survivorship bias: There is a natural tendency to evaluate the world around us based on what we see and remember. That can lead to a somewhat distorted view of how stocks behave over the long run.

One of my favourite examples of this is the case of the forgotten and then found stock certificate. It resurfaces every few years. A classic example is the man who in 2000 discovered he owned EMC shares purchased for about $16,000 a year earlier that now were worth about $5 million; a more modern example is a forgotten and rediscovered purchase of bitcoin.

The purported lesson is that if you just buy a good stock or asset, and forget about it for a few decades, you can become rich. I suspect that is what the GE employees (and all too many others) were thinking when they overweighted their retirement accounts with company stock.

But the problem with this concept is that these stories are newsworthy only when they show great wealth creation. To those who discovered dusty old shares of Enron or Lehman Brothers in 2015, no one would write the article "Local man finds worthless paper in attic".

This is a classic example of survivorship bias, and it can skew investor expectations for future returns of individual investments.

Failing to appreciate diversification: People don't understand the value of having a broadly diversified portfolio. Perhaps they think it shows a lack of corporate loyalty to their employer; maybe it reflects a bit of a lottery-ticket mentality that perhaps your employer is the next Apple or Amazon or Alphabet (Google). Wishful thinking might suggest diversification is giving up a potential fortune.

But every worker who gets company stock also gets a salary from that same employer. That is a very intense concentration of financial risk. For those workers, diversifying their company stock into broad indexes is the prudent approach. They won't become Jeff Bezos, the world's wealthiest person, but they will have happy, well-funded retirements. This is a rational and prudent trade-off (especially since almost none of us is going to become the next Jeff Bezos anyway).

Risk and reward are closely related: The flip side of all high expected returns is increased risk of lower returns. To me, this is the single most important rule of investing. To get better than average returns you must be willing to accept higher - sometimes much higher - levels of risk. This means that sometimes, you will receive lower returns and even losses. This is how investing works.

The inverse is that if you want safety you must accept the inevitability of lower returns. Failing to understand these simple principles is the biggest error almost all individual investors make.

Failing to create a financial plan: All of this comes back to the basic question of why invest in the stock market in the first place. If your goal is to become rich, then (hopefully) you understand the odds, and sometimes the roll of the dice goes against you. But the more rational goal for most employees of big companies is to have more measured objectives: saving to buy a home, paying for the kids' college, and most important of all, securing a comfortable retirement.

If those GE employees had created a long-term financial plan, I believe it would have been obvious to most if not all that they were taking on more risk than was necessary to achieve those goals.

The fall in GE's shares has caused many people a lot of pain. It could easily have been avoided.

- Bloomberg