In my first article in this series about behavioural investment, I looked at some of the cognitive biases and emotional responses that prevent investors from optimising returns from their portfolios over the longer term. I mentioned the cognitive bias of ‘loss aversion’, the human tendency to avoid the possibility of losses today even at the cost of foregoing the probability of higher gains in the future.
This bias emerges strongly as people approach retirement age. According to conventional wisdom, an investor should, at this time, switch from higher-risk investment classes like shares to lower-risk vehicles such as cash and bonds. Isn’t it sensible to stop taking risks with your capital when you stop working since you might not have the time to weather a market downturn, nor the ability to generate more income and rebuild your capital?
That common sense no longer applies in a world where it is not unusual for a person to live for 20 to 30 years after retiring at 60 or 65 years of age. Paired with the fact that we live in a time of persistently low-interest rates, rising longevity means that many retirees with overly conservative portfolios face the real danger of outliving their money. After taxation, returns on capital invested in a money market account do not keep up with inflation, meaning that the value of your capital is eroding with each year that passes.
It is true that returns from South African equities haven’t been particularly great over the past three to four years, but it is also true that people approaching retirement age need to take a longer view of their portfolios than they did in the past. When you start to look at your portfolio over a 10 to 20-year horizon, rather than simply hoping to generate enough income to pay your living expenses, the logic of living off an annuity product or the interest from a money market account does not add up.
As an illustration, our analysis shows that equities in South Africa delivered real average annual returns (above inflation) of 8.4% over the last 28 years. This growth, however, did not take place in a smooth, consistent manner. In fact, over a quarter of the period, investors experienced a negative real return across three years. But local equities caught up after each period of negative real returns, with an average real return of 13.7% for every three years after a three-year period of negative real returns. This pattern is consistent over the 28 years we looked at.
The following charts, courtesy of Prudential, depict the difference that an additional expectation in real growth of 3% per annum can make to the expected lifespan of a retirement portfolio.
Of course, this is not to suggest that you invest all your retirement funding in Netflix stocks or cryptocurrency futures, but rather to point out that it’s important to maintain a balanced and optimised portfolio, even after retirement. You cannot guess when markets will rise or fall, but you can manage the risks of volatility without compromising growth.
A consistent, diversified portfolio across geographies and asset classes can mitigate risk while achieving real growth in your capital. One of the biggest risks is that of allowing inflation to erode your capital – and it’s a danger you must manage alongside the threat of market volatility.