It is always sad to tell retirement-track defined contribution pension plan members that their dreams of winters in Fort Lauderdale and summers at the lake are unrealistic. It is doubly unfortunate, however, to discover that these individuals could have achieved their dreams had they not fallen prey to common investment myths.
Perhaps the proportion of employees making ill-informed investment choices is no greater today than it was 10 years ago, but now that financial markets are so volatile, plan members are asking questions in unprecedented numbers. Many commonly asked questions reveal basic misunderstandings of investment principles.
Fiduciary liability prevents human resources professionals from offering investment advice, but the following information can help HR practitioners correct the most common myths investment DC pension plan members hold.
Common myths
I’m going entirely into bond funds at retirement: This old adage has become a myth over the last 40 years because people are retiring earlier and living longer. When the average Canadian retired at 65 and lived until 75, capital preservation — the great strength of bonds and bond funds — made a lot of sense. Today, however, many employees retire at 60 and will live until age 80. As a result their investment portfolios will need a significant growth component (i.e. equity funds) to maintain their retirement incomes.
Everybody is selling their growth funds. I should too: Maybe you should, but certainly not because everyone else is doing so.
Historically, those investors that have made the biggest returns on their investments have been those that bought precisely when everyone else was selling. But, unless you consider a lottery ticket to be an investment, please don’t try to buy low and sell high. The people that do this are called “market timers” and astonishingly few have bought low and sold high with any consistency.
That’s why most financial advisors recommend “asset allocation,” a disciplined approach to selecting an investment portfolio based on a person’s personal goals and feelings about risk, and then sticking to it through good times and bad.
Asset allocation was developed by economics professor Harry Markowitz in 1952 and earned him a Nobel Prize in Economics in 1990.
Many subsequent studies have confirmed that asset allocation produces the least risk for any given level of return.
Suppose you settled on a portfolio with only three components, a bond fund and two asset funds, one a growth fund and the other a value fund, and allocated a third of your money to each.
If you had begun with $3,000 in each and after 12 months the bond fund had grown to $3,200, the growth fund had grown to $3,900 and the value fund had dropped to $2,800, you would then restore the original one-third allocation for each fund.
Of your $900 gain on the growth fund, $100 would be added to the bond fund and $500 to the value fund so that each would have $3,300. By following this pattern year after year, you would on average be buying low and selling high but without the risks of timing the market.
I know I must invest for growth but I can’t sleep at night worrying: There is no “must” in investing. If the volatility makes you uneasy, stick to a more conservative asset allocation model. This will provide less volatility but will likely result in lower long-term growth.
Some of the worst investment mistakes are made by people that feel uncomfortable with their investment strategies. They become impatient and frustrated as the market declines and sell at the bottom and they are too uneasy to buy back into the market until everyone else is doing it so they end up buying at the top of the market.
Most investors want to feel they are bold risk takers when, in fact, many would rather choose safe and secure investments even if their annual returns were one or two per cent less. That’s fine.
If you want the same capital growth as the more daring investors, simply contribute more cash each pay day to your pension fund, within your employer’s pension plan if that’s allowed or in a personal retirement savings plan if it isn’t.
Everyone says that natural resources prices will do well in 2001, so I’m buying a natural resources fund: Novice investors often make this mistake. They assume, for example, that if profits in a sector such as natural resources rise 20 per cent, the value of their units in a natural resources fund will rise by the same amount.
In reality, the current price of a given company share or mutual fund unit reflects the “discounted value of future returns.”
Let us say that a natural resources sector fund had total returns of 10 per cent this year and is expected to deliver total returns of 20 per cent next year.
The price of a fund unit reflects the expectation of the future 20 per cent return not the current 10 per cent return. It’s entirely likely, in this example, that the price of fund units will actually fall if the fund’s total return next year is only 10 per cent.
My portfolio is down five per cent. Investing is a bad idea: This isn’t heard too often, but it is expected to come up as more year-end statements are issued. The North American stock markets in general, and the U.S. markets in particular, have enjoyed a remarkably long run of growth. For many new investors this is the first time they have actually seen the value of their portfolios decline.
Investors need some historical perspective. A qualified professional financial advisor has access to the latest computer software that allows them to access all historical rates.
Personally, I am more concerned with investors that expect average annual real total returns of 12 per cent over the long term. I fear that some new investors may be basing their retirement plans on these unrealistic expectations.
For HR professionals, there is a key role to play in educating plan members by helping to debunk and correct common myths and manage expectations among their pension plan members.
Asaf Shad is the director, employer services division, Retirement Counsel of Canada, a financial planning firm that works with individuals and employers to provide education. For more information contact (905) 822-8831 or visit www.rcoc.net.
Perhaps the proportion of employees making ill-informed investment choices is no greater today than it was 10 years ago, but now that financial markets are so volatile, plan members are asking questions in unprecedented numbers. Many commonly asked questions reveal basic misunderstandings of investment principles.
Fiduciary liability prevents human resources professionals from offering investment advice, but the following information can help HR practitioners correct the most common myths investment DC pension plan members hold.
Common myths
I’m going entirely into bond funds at retirement: This old adage has become a myth over the last 40 years because people are retiring earlier and living longer. When the average Canadian retired at 65 and lived until 75, capital preservation — the great strength of bonds and bond funds — made a lot of sense. Today, however, many employees retire at 60 and will live until age 80. As a result their investment portfolios will need a significant growth component (i.e. equity funds) to maintain their retirement incomes.
Everybody is selling their growth funds. I should too: Maybe you should, but certainly not because everyone else is doing so.
Historically, those investors that have made the biggest returns on their investments have been those that bought precisely when everyone else was selling. But, unless you consider a lottery ticket to be an investment, please don’t try to buy low and sell high. The people that do this are called “market timers” and astonishingly few have bought low and sold high with any consistency.
That’s why most financial advisors recommend “asset allocation,” a disciplined approach to selecting an investment portfolio based on a person’s personal goals and feelings about risk, and then sticking to it through good times and bad.
Asset allocation was developed by economics professor Harry Markowitz in 1952 and earned him a Nobel Prize in Economics in 1990.
Many subsequent studies have confirmed that asset allocation produces the least risk for any given level of return.
Suppose you settled on a portfolio with only three components, a bond fund and two asset funds, one a growth fund and the other a value fund, and allocated a third of your money to each.
If you had begun with $3,000 in each and after 12 months the bond fund had grown to $3,200, the growth fund had grown to $3,900 and the value fund had dropped to $2,800, you would then restore the original one-third allocation for each fund.
Of your $900 gain on the growth fund, $100 would be added to the bond fund and $500 to the value fund so that each would have $3,300. By following this pattern year after year, you would on average be buying low and selling high but without the risks of timing the market.
I know I must invest for growth but I can’t sleep at night worrying: There is no “must” in investing. If the volatility makes you uneasy, stick to a more conservative asset allocation model. This will provide less volatility but will likely result in lower long-term growth.
Some of the worst investment mistakes are made by people that feel uncomfortable with their investment strategies. They become impatient and frustrated as the market declines and sell at the bottom and they are too uneasy to buy back into the market until everyone else is doing it so they end up buying at the top of the market.
Most investors want to feel they are bold risk takers when, in fact, many would rather choose safe and secure investments even if their annual returns were one or two per cent less. That’s fine.
If you want the same capital growth as the more daring investors, simply contribute more cash each pay day to your pension fund, within your employer’s pension plan if that’s allowed or in a personal retirement savings plan if it isn’t.
Everyone says that natural resources prices will do well in 2001, so I’m buying a natural resources fund: Novice investors often make this mistake. They assume, for example, that if profits in a sector such as natural resources rise 20 per cent, the value of their units in a natural resources fund will rise by the same amount.
In reality, the current price of a given company share or mutual fund unit reflects the “discounted value of future returns.”
Let us say that a natural resources sector fund had total returns of 10 per cent this year and is expected to deliver total returns of 20 per cent next year.
The price of a fund unit reflects the expectation of the future 20 per cent return not the current 10 per cent return. It’s entirely likely, in this example, that the price of fund units will actually fall if the fund’s total return next year is only 10 per cent.
My portfolio is down five per cent. Investing is a bad idea: This isn’t heard too often, but it is expected to come up as more year-end statements are issued. The North American stock markets in general, and the U.S. markets in particular, have enjoyed a remarkably long run of growth. For many new investors this is the first time they have actually seen the value of their portfolios decline.
Investors need some historical perspective. A qualified professional financial advisor has access to the latest computer software that allows them to access all historical rates.
Personally, I am more concerned with investors that expect average annual real total returns of 12 per cent over the long term. I fear that some new investors may be basing their retirement plans on these unrealistic expectations.
For HR professionals, there is a key role to play in educating plan members by helping to debunk and correct common myths and manage expectations among their pension plan members.
Asaf Shad is the director, employer services division, Retirement Counsel of Canada, a financial planning firm that works with individuals and employers to provide education. For more information contact (905) 822-8831 or visit www.rcoc.net.
