The gambler's mistake
15 June 2015
One of the main challenges of investment is to manage risk. That in turn means managing volatility. The AFR is reporting on the work of John Evans, associate professor at Sydney Business School, who has studied the impact of market gyrations on retirement incomes:
"The findings are not pretty. Admittedly using a list of assumptions as high as a flagpole, Evans concludes that individuals who contribute the same amount to super over a lifetime of work will have vastly different balances at retirement, depending on whether the markets ebb or flow.
Different cohorts of savers will be forced to live off anywhere between 40 per cent of their final salary and five times their final salary, depending on whether markets rise or fall – and when in the saver's life cycle this happens.
Of even those savers who understand that the amount of money they will have in retirement is linked to the prices of investments such as stocks and bonds, few would realise that the divergence could be quite this wide. Evans said he was not expecting such diverse results."
Over 90% of the divergence in investment results are attributable to asset allocation. What is also known is that moving in and out of markets almost certainly depresses the returns because of the overwhelming temptation to buy high and sell low. The problems of the herd instinct are well known, but it is still very hard to resist the herd:
"The study shows that the luckiest couples who work for 42 years and retire at the age of 67 will be able to support an income that is more than five times their final salary if there are no investment shocks over that period. Even without a big market crash, the unluckiest couples will retire on a sum that will force them to survive on just 45 per cent of their final salary, assuming they are eligible for the age pension. The difference is explained by market volatility and when any nasty falls occur, because Evans assumes that all gains and losses are effectively crystallised at retirement.
The issue is what to do about the vastly different outcomes that can occur because of the timing and extent of market fluctuations. A government might, or might not, care about market luck, but it might care about the impact of a market downturn on the pension bill. In 2008 there was a hefty rise in the number of Australians claiming the age pension. Still, before any government would want to give a policy response to findings such as these, it would be useful to have in place the goals of Australia's retirement income system. We are not there yet."
What is implied in this is that there is a certain amount of luck involved. But luck should not be the determining factor in investment. It should not be a gamble. What investors should do over the long term is assume that market fluctuations are inevitable and plan accordingly. That takes the luck out of investments, whihc means changing your risk profile as you get nearer to retirement.