401(k) Plans Are Designed for Mediocrity

HUNT VALLEY, Md. (TheStreet) -- Your 401(k) account probably contains 10 to 20 investment choices. In that group, there are likely five or more lifestyle or target date funds, which really are not specific investment options. A lifestyle or target date fund is one that manages the employees' money between stocks, bonds and cash based on the age of the participant. The closer participants are to retirement, the more they will be in bonds and cash. The younger participants are, the more funds are invested in equities.

The other funds offered in a 401(k) normally are a mix of large cap, midcap and small cap, bonds and international funds. The reason for this small, diverse group of funds is to allow people to create an asset allocation model based on the efficient market theory -- which is blatantly false.

Those who want to invest like Warren Buffett, with his frequently great returns, have to first understand Warren Buffett.

Understanding the typical investment will help people understand why 401(k)s are intentionally designed for mediocrity.

First, let's examine the lifestyle or target date funds. The concept that age dictates investments is foolish. Let's assume it's 1966 and you have $100,000 (a great deal of money in those days) and are 50 years old. Over the next 15 years as you approach retirement this age-investing philosophy would have moved you out of stocks and into bonds at the worst possible time. Age should affect goals, but never the actual investments.

Age determines goals, and goals will determine the rate of return needed to achieve them; then investments can be reviewed to find the risk opportunity investments that may accomplish the various goals. There are thousands of investment opportunities to consider, and an investor should never assume one security as the go-to choice because times will, and will continue to, change.

As for other funds available for developing classic asset allocation, the problem lies in the next amazingly foolish concept ... that markets should be invested in only over the long term. This is based on the so-called "Efficient Market Theory."

Simply put, the theory says markets are efficient and cannot be beat, so invest and stay invested. Even though there are investors who have bested the market for decades, the theorist retort is that these people are anomalies and should not be considered.

Asset allocation is the outgrowth of "The Efficient Market" in that a person invests a portion in five or six asset classes and holds on for the long term. This concept is alien to the great investors of the world. Great investors have always been risk managers, not buy-and-hold investors.