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Unlearned lessons in 401(k) investing

/ Source: The Associated Press

Apparently, the billion-dollar losses in retirement savings by employees at Enron, WorldCom and Global Crossing were not enough of a warning. Workers are still keeping an outsized portion of their nest eggs parked in their employer's stock.

Among workers at major companies with 401(k) money invested in their employer's stock, those shares accounted on average for 40 percent of the entire account balances, according to a study by Hewitt Associates spanning nearly 1.5 million plan participants.

Worse, about one fourth of those people had more than half their 401(k) savings allocated to the company's stock, as did nearly a third of those workers approaching retirement age, the consulting firm reported.

Granted, these numbers don't approach the extreme situation that preceded the train wreck at Enron, where about 20,700 participants in the 401(k) plan had nearly two-thirds of their assets invested in company stock.

But while it may sound alarmist to conjure up a disaster like Enron, it isn't just the relatively remote possibility of outright scandal which makes it a perilous decision to risk so much money into a single investment vehicle.

There are countless approaches to investing, many of them contradictory, but precious few that don't recognize the importance of diversifying a portfolio to hedge against the unexpected. And while there's some debate over how many different stocks are needed in a portfolio to provide the maximum benefit of diversification, the answer is never one.

The reason? No matter how bright a company's prospects may appear to an enthusiastic worker, things go wrong.

Lifestyles change. New technologies arrive. Cheap imports start flooding a market. A new drug flops. Products are recalled. An Arab oil embargo make drivers seek alternatives to American gas guzzlers. Record albums and VCR's are replaced by CDs and DVDs, which are replaced by digital downloads. People avoid red meat after a mad cow outbreak. Atkins dieters avoid Krispy Kreme doughnuts and other high-carbohydrate foods.

Or, a bubble bursts, and an economy sours.

Although the collapse hit the technology industry hardest, plenty of workers at non-technology companies with their employer's stock in their 401(k) accounts suffered brutal losses. Among the 30 stocks in the Dow Jones industrial average, Microsoft Corp. and Intel Corp. were joined by names like General Electric Co., McDonald's Corp. and Merck & Co. in losing half their value or more from their heyday highs.

For current retirees or any workers nearing that stage, those losses may never be recovered. And while there's a chance that workers who are years away from retirement may eventually see their company's stock recover all the lost value, it would be far safer to bet on a rebound by a multitude of companies rather than a single stock.

So why do investors continue to pile money into an employer's shares?

Beyond company pride or enthusiasm, one factor is that some employers make it difficult to diversify, while others inadvertently lead their employees down an imprudent path.

Oddly, the problem can start with employers who match some of their employees' contributions to retirement savings.

Sixty-three percent of large public companies offer their own stock as an investment alternative for 401(k) plans, and more than a third of those only pay their matching contributions with stock. Most of those plans restrict when employees can sell those shares. Such restrictions include making employees wait until they're 55 or have participated in the 401(k) plan for a certain number of years.

In addition to concentrating a major source of an employee's retirement savings into a single stock, these policies also have a habit of playing on well-documented psychological tendencies among investors.

Simply put, investors can fall prey to the power of suggestion, what researchers call an "endorsement effect."

Several studies have shown that when a company requires its shares as the currency for a matching contribution, participants also put a bigger portion of their own 401(k) contributions into that stock as well.

Researchers suggest that some people, intimidated by investment decisions in general, may perceive the matching policy as investment advice or validation of the stock as a safer investment vehicle.

Fortunately, the number of companies who give employees more flexibility with 401(k) allocations is on the rise, Hewitt says.

Some companies also are starting to be more proactive in educating employees about the need for diversification. A handful are even reaching out to specific employees whose allocation is sharply tilted toward the company's shares. Such efforts are tricky, however, because some employees find it intrusive, while others may be well diversified outside their 401(k) savings,

Either way, employees bear ultimate responsibility for their own good. That means spreading out their investments enough to reduce their exposure to poor performance by a single security, whether due to poor execution, changing market pressures or outright scandal.