How the behavioural gap can jeopardise your retirement savings

The average investment fund underperforms the index by around 2% per year, with the average investor underperforming the average fund by a further 2% to 4% per year. This happens as investors chase past performance and switch funds based upon what has worked in the past.

This is according to Steven Nathan, Chief Executive Officer of 10X Investments, who says that despite fund members wanting to maximise their returns without taking unnecessary risks, part of the challenge they face is the behavioural gap - whereby investment decisions are likely to be done irrationally and emotionally, instead of using a more logical and tempered approach. “Even if we know what we should do, we are likely to be tempted to behave irrationally and emotionally.”

Nathan says that fund members and investment managers alike tend to behave with a number of behavioural biases when making investment decisions, which includes over-confidence and a herd mentality. “Part of the challenge is that most people think that they are above average, which makes them confident enough to back themselves and others, in order to beat the odds when investing.”

Recency bias causes investors to place far more importance on what has happened recently and extrapolate recent events in the belief they will persist, which is why investors often chase past performance, he says. “Investors get more confident after equity markets have performed well and equally get more despondent after markets perform poorly. As a result, we buy high and sell low, which is the opposite of sensible investing. Investment professionals also suffer from this irrational behaviour. The investment industry implies that it has a crystal ball and knows when investment markets are cheap or expensive and can outperform by timing markets.”

Part of the challenge is that most investors find comfort in what others are doing and tend to follow their actions without taking into account their own best interests, he says. “The industry as a whole understands that these behavioural weakness help drive investment decisions and capitalise on them by creating products that appeal to our emotions.”

Nathan points out that long-term expected real returns on a high equity balanced portfolio are around 5% to 6% per year, with each 1% saved increasing a person’s final pension by approximately 30%. “A new approach is needed by fund managers that help retirement savers maximise their long-term investment returns. This approach needs to address the inclination to make irrational investment decisions and needs to remain robust, as it needs to last 40 years and longer – up to 60 years if we invest in a living annuity.”

Nathan says that the ideal investment solution should automatically invest people according to their investment time horizon, in that way the advice is embedded in the portfolio already. “Investors should own index funds in their investment portfolio in order to capture the full market return. It is also important that total fees are minimised to ensure more of their savings are invested and that they capture more of their investment return. Once they have done this, they need to remain steadfast in their investment decisions through good and bad periods, as well as avoid the industry’s marketing temptations and its own behavioural biases. If consumers do this and save diligently (15% of their salary for 40 years), they are highly likely to have a more financially secure retirement. The unfortunate reality is that 90% of South Africans fail to accumulate an adequate retirement fund, by not following these simple yet profound rules.”

He says that retirement savers shouldn’t be tempted to chase past performance or believe that ‘this time is different’, as many people did after 2008 when experts forecast the end of capitalism and a return to the gold standard. “Be sceptical about people who say that they can predict the future and earn higher returns. In addition, fund managers shouldn’t offer too many investment choices, as the majority of investors will destroy substantial value when exercising investment choice - anywhere between 2% and 4% per year,” concludes Nathan.