How do you ensure a comfortable retirement? Financial planners say if you invest 15% of your monthly salary over 40-years (from age 25 to 65) you should have enough to achieve a net replacement ratio of around 75%. This means your ‘salary’ in the first year of retirement will be 75% of the salary you earned in the final year of employment. There are some other rules, the most important being that you religiously preserve your retirement capital in the event you change employment.
Of course your disciplined savings plan will come to nought unless your invested funds earn real returns. You must earn a return in excess of the prevailing inflation rate to protect the purchasing power of your savings. How important is investment return? Alexander Forbes Financial Services says that every rand spent in retirement is made up of retirement contributions (23%), in-fund investment returns (41%) and post-retirement investment returns (36%). News flash! It’s the return on your savings that sees you through retirement. “More than three quarters of the return you get from your retirement savings is coming directly from investment returns,” notes Trevor Abromowitz, the group’s Head of Asset Consultants.
Understanding investor behaviour
Your long-term relationship with money and investing influences your ability to retire comfortably. Attempts to better understand the link between emotion and financial decisions ‘birthed’ a new field of study, behavioural finance, a complex mix of psychology and sociology. On 5 May 2010 Alexander Forbes hosted a media presentation to discuss the impact of such behaviours on South African investors.
Abromowitz touched on a number of far-reaching behavioural finance themes such as overconfidence, myopic loss aversion, regret aversion and herding. The first observation was that the daily movement of stock market prices is similar to a coin toss. If prices have moved higher on nine consecutive trading days, the chances of another ‘up’ day remain 50/50. This clearly illustrates the pointlessness of attempting to predict the future based on the past. Overconfidence is a major behavioural challenge. People are inherently overconfident – just ask a room full of people how many believe they are ‘better than average’ drivers and you’ll get a show of 80% of the hands. “An overconfident investor trades more often than he/she should,” observes Abromowitz. The result is higher investment costs and below average return!
Myopic (or short-sighted) loss aversion is a technical term describing an investors’ reaction to short-term profits and losses. An investment loss weighs on the average investor far more than a profit, with loss positions triggering emotional rather than rational responses. Regret aversion deals with how investors handle their past decisions. “People are very aware of the consequences of their actions, but far less sensitive to the consequences of their inactions,” notes Abromowitz. If you lose R20 000 by switching funds you feel responsible for the ‘loss’ because you made the decision. But if your net position was R20 000 worse because you stayed in the wrong fund you feel no accountability.
Avoid following the herd
Investors who ‘follow the herd’ are largely responsible for stock market bubbles. Herding is a so-called ‘social proof’ phenomenon best illustrated by the buying frenzy at the height of a bull market rally. Everyone was talking about the massive gains on offer prior to the dotcom bust. The ‘herd’ rushed in so as not to miss out on this easy money. And the ‘herd’ lost everything when prices subsequently collapsed. Herding behaviour makes Ponzi schemes possible. Investors backed Madoff’s funds because ‘everyone else was doing it’ rather than for any concrete reason.
We witness the impact of behavioural finance decisions on a daily basis. A recent press release from the Association of Savings and Investments South Africa (ASISA), titled Nervous investors lose out as market timing fails, shows how investors allow emotions such as fear and greed to influence their investment decisions. They move out of equities in favour of ‘safe’ cash investments the nearer a market gets to its bottom – and reverse the process when equities become expensive again! ASISA chief executive, Leon Campher, says the JSE All Share index returned 44% in the 12-months to March 2010. “Unfortunately most investors wiped out their share of these gains by hopping in and out of equity exposure every time the market sighed!”
How should you adopt your long-term investment strategies to accommodate your emotion? One way is to stick with objective tools and measures when making decisions. It’s much safer to follow a ‘tried and tested’ investment formula than to fiddle with your portfolio on gut feel. A retirement plan requires that you mitigate risk rather than maximise return. Abromowitz sums it up rather nicely: “The objective is to achieve a reasonable pension that will last a lifetime.”
Editor’s thoughts: Retirement planning requires a long-term commitment. But you might not have to be as ‘hands on’ as you previously thought. Your role is to save enough of your monthly gross, contribute consistently to your retirement fund, and preserve your retirement capital when you change jobs. You can leave the ‘nuts and bolts’ to the financial planning professionals. Do retirement savers have too much choice for their own good? Add your comment below, or send it to gareth@fanews.co.za
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Added by Nancy Bowring, 11 May 2010