Playing with 401(k) fire

NEW YORK (Money) -- Question: In December, 2005 I spread the $200,000 in my 401(k) account across funds that had gained 20 percent or more a year over the previous three years. Those funds gained about 30 percent in 2006. I'm following the same strategy this year and so far I'm up about 30 percent. I should add, though, that following this strategy has put about 65 percent of my money in foreign stock funds, and I've also ended up with several sector funds. I've got another 10 to 15 years before I retire. Am I being brilliant or blissfully ignorant of risk? - Forrest, Madison, Alabama

Answer: You could be both for all I know, and just plain old lucky too for that matter. The real question is whether it makes sense for you to continue following your "invest in the stars of yesteryears" strategy or whether you should take a more conventional approach and build a truly diversified portfolio.

At the risk of sounding like a narrow-minded fuddy-duddy unwilling to think outside the box, I have to say that, despite the tantalizing returns you say you've earned so far, I can't recommend that you stick to this strategy or that anyone else adopt it.

I know that I wouldn't (and don't) invest my own retirement money this way. And I can't in good conscience suggest that you do. Here's why. Mechanistic investing systems have been around a long time. The variation you're using is basically a form of momentum investing, the basic principal of which is that an investment that's done well recently will continue to do well at least for some time in the future.

The idea is similar to Newton's first law of motion, which says that a body in motion tends to stay in motion unless acted upon by an outside force (in the case of investing, that outside force would be a shift in the markets). There are a variety of ways to employ a momentum strategy - you're going with three-year performance, but others have gone with one-year performance or other time periods.

Other people take the opposite tack - that is, buying investments others shun (or funds whose investment strategies are out of favor) on the theory that these investments and funds will bounce back.

Basically, this is a form of value investing and the Dogs of the Dow strategy - buying the highest-yielding Dow stocks each year - is one of the better known ways of pulling it off. [See correction below.] And there are countless other systems out there floating around.

Indeed, I get inundated on a regular basis with emails and snail-mail from investors, marketing organizations and others touting all sorts of algorithms, processes, systems and schemes that purport to beat the market, identify the best stocks or mutual funds, guarantee high returns at low risk or do all of these things combined.

Do they work? That's hard to say. I'm sure that most systems can point to some periods where they've had success. In fact, most of these systems are created by trying a variety of strategies and "backtesting" them - that is, see how they performed in the past.

But the fact is, determining whether a system that's done well in the past is likely to go on doing so because it tapped into some fundamental market "truth" or whether it worked well because market forces just happened to be aligned in a particular way that may not be repeated in the future would require tons of time and effort.

Indeed, you could spend your life trying to validate (or invalidate, as the case may be) the seemingly endless stream of foolproof investing systems. So while I can't tell you that your system or anyone else's is flat-out wrong or doomed to fail, I can say that just because a stock or fund turns up at the top of a list or screen doesn't mean its presence there is meaningful.

Would it matter to you if the fund you were about to buy because it passed your three-year performance screen was being run by a new manager who arrived within the last year or so and thus had nothing to do with the fund bubbling to the top of the performance charts? Or how about if the fund had changed its investing focus over those three years? Or had zoomed from $100 million in assets to $1 billion? Do you think such factors might affect future performance?

Suffice it to say that, just as I'm wary of fad diets and dietary supplements that promise huge weight loss, I'm also leery of any mechanical system that suggests you can get results well beyond the raw returns the financial markets offer. We'd all like to find some secret formula that leads to blowout returns. But in my experience the world doesn't work that way. And in my opinion, people who believe there are such magic-bullet solutions are deluding themselves.

That's not to say that you may not continue to rack up decent or even impressive gains for a while. On the other hand, it's also possible that a major turn in the market will wreak havoc with your portfolio, much the way the bottom fell out of tech and other aggressive growth stocks after the 1990's boom. This may be a particular danger for you in that your system has led you to a concentration in foreign stock and sector funds.

Foreign stock fund returns have been particularly strong lately in part because of the weak U.S. dollar. A rebound in the greenback combined with a natural downturn in foreign markets after a nice run-up could inflict a big hit on a 401(k) that's invested so heavily in foreign shares.

As for loading up on sector funds, well, they're inherently volatile because they home in on just one area of the market. If you want to see how much their returns can jump around, just go to the Category Returns section of the Funds section of Morningstar and check out the performance of some of the funds in specialty areas like technology and precious metals.

All of which is to say that I think you're much more likely to accumulate the nest egg you'll need for retirement by taking a more traditional approach. Start by creating a mix of stocks and bonds that makes sense for someone your age and with your tolerance for risk. For more guidance on how to do that, click here and here. Then, choose funds that have low annual costs and that have a solid record of delivering consistent gains. Note that I said "consistent," not funds that have the highest gains in any given year.

You can find such reliable performers in the Money 70, our list of recommended funds. If your 401(k) doesn't offer any of these choices, you can at least choose from among your 401(k)'s lineup using the same fund-picking philosophy we used to come up with the Money 70.

And if you want to tilt the odds even more in your favor, you should consider putting the bulk of your retirement money in index funds, assuming your 401(k) plan offers them, as most plans do nowadays. The combination of index funds' low operating costs and their consistent investing style makes it likely they'll outperform most other funds over the long term.

I'm not going to claim that my approach will generate the highest returns. Indeed, by spreading your money among a variety of asset classes you virtually assure that your portfolio overall won't do as well as whatever funds are topping the performance charts in any given year. But if you follow my advice, you will be investing in a way that allows you to earn competitive returns while also protecting yourself somewhat against market setbacks.

I don't think you can say the same with what you're doing, particularly as regards risk since you end up with such a concentrated portfolio. Ultimately, it's your decision whether to continue investing on the basis of your system. But if I were you I'd thank fate, the investing gods or whatever and get out now while I'm ahead - or at the very least greatly reduce the amount of money I invested using this strategy. I'm all for experimentation. But not at the expense of my retirement.

CORRECTION: An earlier version of this story referred to the Dogs of the Dow strategy as buying the lowest-yielding Dow stocks. In fact, the contrarian investing strategy advocates buying those Dow stocks with the highest dividend yields, which are often the mark of a depressed stock price.