The conference launched with a panel discussion that included Ismail Momoniat, Deputy Director General (Tax and Financial sector) at National Treasury. Mr Momoniat did not mince his words: with just about all the large retirement fund players attending, he lambasted the industry for its unwarranted complexity, lack of passive investment strategies and high fees.
Steven delved deeper in to these issues in his presentation. He posed the following question: given the choice to invest R1 000 per month for 40 years in a strategy that delivered either a 2% or a 5% real (after-inflation) return, which would the majority of investors in South Africa choose? It is a critical question, of course, as someone investing at 5% pa will, after 40 years, receive double the benefit (R1.5m) of someone earning only 2% pa (R700k).
Why do the majority of savers make this seemingly irrational choice? And why is there no safety in this crowd?
The answer, of course, is that most investors do not understand the consequences of their investment strategy, or even that they have chosen this strategy. Academics blame this on the “lack of informational symmetry”, a polite reference to industry’s deliberate complexity and opacity, which prevents investors making informed decisions.
Three investment mistakes that cost your dearly
So what are the three strategic investment mistakes – propagated by the retirement fund industry – that cost you up to 3% pa of their return over time?
The first is making poor investment choices. This manifests in two ways: chasing past winners and selecting the inappropriate asset mix.
Investors have a natural and understandable urge to go with the star fund managers, who have delivered the best performance in a particular category over a particular period, or even those who have delivered consistently over some years. Unfortunately, performance persistence – delivering top quartile results on a regular basis – is rare. Often, the high ranking is due to a combination of both skill and luck, and both these qualities tend to be quite evenly spread among asset managers. So selling the underperformers to buy the outperformers is often tantamount to buying high and selling low.
Or, to quote John C. Bogle, the founder and former CEO of the Vanguard Group –and pioneer of index investing, “the stars produced in the mutual fund field are rarely stars; all too often they are comets.”
Another problem is that many investors do not tolerate losses very well. Again, this is understandable. No one wants to commit money to the share market and see its value fall shortly after. This engenders a sense of regret, either at the avoidable loss or at the poor market timing. Behavioral finance studies show that the average investor would rather avoid a loss than realize a profit. For this reason, they invest in a medium rather than a high equity portfolio, as this is likely to have less volatile returns and less downside risk. Unfortunately, it is also likely to deliver a lower return over time.
The second strategic mistake most investors make is choosing the active fund management route. Active fund managers apply stock picking and market timing in the belief they can deliver an above average return (the average return being the benchmark or market return of a particular asset class). This is expensive and generally does not yield great results. Within the confines of a zero-sum game (the market return is finite over any given period), reasonable market efficiency, and the absence of performance persistence, it is almost impossible to separate the few long-term winners from the many long-term losers.
In John Bogle’s words, “Funds with long-serving portfolio managers and records of consistent excellence are the exception rather than the rule.”
Given that the great majority of fund managers fail to beat the market after fees over the long-term, the average investor would have been better off simply earning the average market return.
This brings us to third fatal investment mistake: paying high investment fees. Fees must be seen in their proper context, not relative to assets, but relative to the long-term real (after-inflation) return. This is the return that actually builds wealth. For a balanced portfolio, a prudent real return assumption is 5% pa, before fees. In this context, it is immediately obvious that paying a fee of 3% pa (the retail average in South Africa) will reduce your real return by 60% (and closer to 75% if we include the compound effect over 40 years).
Fees turn the zero sum game into a losing game as the average investor earns a return far lower than the average market return. The winners of this losing game, on average, are the investors who pay away the least amount in fees.
So how can you avoid these three ruinous mistakes?
Firstly, abstain from exercising investment choice, fund switching, and following the latest investment fad. Instead, adhere to an optimal asset mix, based on your age and expected investment term (‘investment term’ refers to the time period until you plan to convert your investments into cash).
Understand that time and diversification reduces risk. The best return of a high equity portfolio in South Africa over any 40-year period since 1900 has been 8.3% pa and the worst 4% pa. By comparison, the best return from a medium equity portfolio has been 7% pa, but the worst return has only been 2.6%. In other words, owning a high equity portfolio actually produces higher long-term returns with lower risk.
Owning a low or moderate risk portfolio over the long-term may well deliver less volatile returns year to year, but it will also deliver a much lower – and probably insufficient – return measured over the entire period.
Only nearer the end of the investment term does short-term volatility threaten your savings outcome, at which point it will be prudent to start moving into a lower-risk portfolio.
Secondly, avoid active fund managers. Yes, some may do very well for you, but the great majority will likely deliver a below-average return. The simple solution is to buy an index solution that replicates the market return at very low cost. This performance is sure to beat the vast majority of active fund managers over time.
Thirdly, avoid high fees and choose a low-cost service provider. Ideally, you total annual investment cost should not exceed more than 1% pa over the lifetime of your investment.
Retirement investors can avoid all three ruinous mistakes by investing in one of 10X’s retirement products, either the 10X Umbrella Funds (for group schemes), in a preservation fund or retirement annuity fund.
