A 401k plan is an employer-sponsored retirement account. Typically, employees contribute some of their pre-tax earnings to a 401k, and their employer matches a portion. The resulting balance is then invested, allowing employees to earn interest. While 401k plans offer employees control over how their money is invested, frequent trading is often discouraged or even prohibited by specific plans.
Role of Trading in a 401K
Trading is essential to ensuring that investments are balanced in a way that takes into account a participant’s individual level of risk aversion and intended retirement date. Participants in 401k plans tend to trade infrequently, according to research by Vanguard, likely because of lack of experience in trading and fear over executing poor trades. In general, traders get better returns than non-traders, even though they also assume more risk.
Problem of Excessive Trading
Simply putting your money in a 401k plan and never trading to ensure your investments will meet your monetary needs at retirement is a bad strategy. On the other hand, trading frequently is no better. While traders assume more risk than non-traders, frequent traders can assume excessive risk, and in general, frequent traders’ investments don't perform as well. “Since high turnover harms investment performance, discouraging active trading -- through education, plan policies, or fees -- should produce superior risk-adjusted returns,” notes a Vanguard white paper from 2007.
Reading the Fine Print
That’s not to say that frequent trading is not allowed by your individual plan; it may very well be. Check your plan documents to see if there is an excessive trading policy. Look for wording about “round trip” transactions. These are a sale, followed by a purchase, within a specific amount of time -- essentially trading. Even if there is no excessive trading policy in place, you may be subjected to fines. Find out if there are any such fines, and if so, the trading threshold at which they are imposed. If the fine print is difficult to decipher, call your plan administrator and ask a representative directly.
Violating a plan’s excessive trading policies can, in addition to fees, result in a trade being rejected. Such policies are in place largely to ensure maximum returns for 401k plan participants. Most participants in such plans are simply not sophisticated enough to trade frequently and come out ahead. Remember, you’re not just gambling with your own money, but also with your golden years.
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