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© Copyright 2000 Rogers Media. The following article first appeared in the April 2000 edition of
BENEFITS CANADA magazine.
Looking for direction
Too many DC plan members are making classic mistakes. You can help.
By Harry S. Marmer
Defined contribution (DC) pension plan investors need to make smart investment decisions so that they can
build up a golden nest egg to allow them to successfully retire. Unfortunately, some DC investors make
classical mistakes that can stack the deck against them. These pitfalls are easy to fall into, but plan
sponsors can help employees avoid them.
BUYING HIGH, SELLING LOW
A recent study found that over a 10-year period, the average U.S. equity fund returned 12.3% while the
investor in these funds earned on average 6.3%. The fact that there is a high correlation between fund
performance and cash flow reflects the tendency of individuals to buy high and sell low (i.e. there is a
high correlation between fund performance and cash flows). This is also known as "barn door closing,"
meaning that investors often do something today that would have been profitable yesterday.
Why investors buy high and sell low can be mostly attributed to pride-seeking behaviour as well as the fear
of regret. Pride-seeking refers to the need to feel good about decisions. Fear of regret leads to avoidance
of the pain and responsibility of poor decisions. Correspondingly, pride-seeking leads investors to buy
high, by investing in funds with the latest hot track record, so that they can be winners and feel good.
Fear of regret, meanwhile, causes investors to sell low as they hold on to losing funds too long in the
hope of avoiding the inevitable loss.
These two causes of decision-making error fall under the broader topic of behavioural finance, which
concerns itself with investors acting in a non-rational, but normal, human behaviour mode.
In helping your DC investors avoid buying high and selling low, education should emphasize why past
performance is not indicative of future performance as well as stressing the need to focus on total fund
performance as opposed to individual manager performance. Sponsors can improve the system by taking an
active role in the firing of managers as opposed to relying on investors to do the firing.
NAIVE DIVERSIFICATION
Numerous studies have shown that investors use simple rules to make complex decisions. For example, if you
offer more bond funds than equity funds, your DC investors will tend to have an asset allocation that leans
towards bonds as opposed to stocks (see "The power of suggestion," below). This is reinforced by investors'
tendency not to look at the asset allocation decision from a total portfolio basis but instead as separate
accounts that should be independently assessed.
Education can help avoid naive diversification asset allocation by leading investors through a
decision-narrowing process that takes the asset class relationships into account. In addition, sponsors can
help plan members avoid naive diversification by taking the initiative to label certain fund choices as
core offerings, as well as providing life cycle funds.
PROBLEMS IN MANAGER STRUCTURE
It is a widely accepted paradigm that for active investment management, both style and manager risk is
significant but diversifiable. That's why large defined benefit (DB) plans invest their pension assets in a
multi-style, multi-manager structure. Yet most DC plans continue to be managed using the old-style balanced
fund manager structure, where a couple of managers offer their product line to investors. DC sponsors have
found themselves in this predicament because when most of them started off their DC programs, they were
framed as being relatively small plans, which, like smaller DB plans, could be easily managed on a balanced
fund basis. This phenomenon is compounded as new DC plans look to anchor their fund structure by examining
what other DC plan sponsors are doing.
The simple, straightforward way for DC sponsors to improve the products they offer to their employees today
is to implement a packaged multi-style, multi-manager structure. This will provide them with a solid active
investment manager structure without the worry of selecting managers.
MARKET TIMING ONCE AGAIN
We all know that successful market timing is difficult even for the experts, and yet we continue to attempt
this investment process. Why is it so hard to successfully slay this proverbial dragon? The case against
market timing can be logically and simply built as follows. Bull markets last longer than bear markets--on
average, four times as long. As well, stocks go up more than they go down--again on average, almost twice
as much. Finally, most up market (or for that matter, down market) performance occurs in unpredictable
spurts. These movements are random and non-forecastable.
Unfortunately, we continue to try to time markets due to either our hindsight biases or overconfidence.
Hindsight bias is also known as "Monday night quarterbacking." Looking back, we had perfect certainty as to
where the market was going. As well, investors are overconfident about their knowledge, abilities and the
future. They are confident that they can predict what lies ahead.
The tendency of investors to try to time the markets can be countered by an education program that helps
investors focus on their long-term asset mix, which should be arrived at by an analysis of their needs,
objectives, risk tolerance and other factors. In addition, packaged life cycle funds that automatically
rebalance can also prevent investors from moving their funds around. Finally, as a last resort, encourage
investors who feel the need to make asset mix decisions to consider dollar cost averaging.
There is a huge need out there to help DC investors make smart investment decisions. Hopefully, these
points will help your plan members.
Harry S. Marmer is director of institutional services with Frank Russell Canada in Toronto.
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