Within the defined contribution (DC) pension investment industry, we have some of the best brains and actuarial talent spending their time and our money creating new strategies and tactics to improve and maximise investment return.
But is positive return really the zenith of DC investing? In the long term, perhaps, but in the short term, especially in the early years of DC build-up, there is a strong case to suggest a DC investor should look for funds with a decreasing unit price. Why?
First rule of investing
Consider the first rule of investing: buy low, sell high. If members understood this basic rule, they would not be concerned, especially in their 20s and 30s, about their fund value decreasing, but would actually embrace falling unit prices.
Buy low, sell high is the investor’s mantra, but does the average DC member think or behave this way? No, and whose fault is this? Probably the industry’s. Members are fed the line that positive returns are good and an increasing unit price means a higher-value DC pot.
But this is only important at one point: retirement. Until then, it is far more to the advantage of the member if the unit price is low or decreasing, so that for the given contribution, which for most is a fixed amount that increases only with a salary rise, he or she will buy more units than would otherwise be the case.
Known as pound cost averaging, this is probably the most important, and yet the most misunderstood, concept for DC investors. A tick shape on a graph that shows unit price over time is the best shape to aim for, much better, for example, than a steadily rising line. In numerical terms, the difference can be substantial.
Behavioural finance shows us that most investors lack the nerve to buy low and sell high. But a DC investor is not a typical investor; the time horizon can be 40-plus years, regular contributions are made over this period, and switching activity is very low in most DC plans. So, pound cost averaging is very important to DC investors and greater understanding of this concept would lead to far better outcomes.
For DC members (especially those with a long time until retirement) who are looking at their account balances, if they have gone down, don’t despair. Instead, rejoice in the fact that you will buy more units at the lower price, so that when the price does go up, you will have more units to sell.
Of course, no one can time the markets perfectly, but for DC members in the growth phase, volatility of prices (because of pound cost averaging) is generally a good thing and should be embraced. It is certainly not in the National Employment Savings Trust (Nest) book of investing, but is worth reflecting on.
Note to DC trustees: offer funds with long-term growth potential and educate younger members.
Matthew Webb is head of international benefits at Thomson Reuters
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