For the last twenty-four years’ or so I have moved in the circles of people who trade the financial markets. People who trade all sorts of instruments in all sorts of timeframes on all sorts of platforms. People on all sides of the financial markets spectrum, people who analyse, trade, advise, report and study the financial markets; individual traders and investors, brokers, institutional traders, money managers, coaches, educators, financial journalists and authors, plus more.
There is a theme which seems to flow through the actions of many of these so-called financially astute people with whom I have conversed over the years that continues to amaze me – it is that the majority of them have their retirement nest eggs invested with active balanced mutual funds of some sort!
They use all sorts of techniques to enter and exit trades, to manage risk and to calculate their position sizes. But when it comes to sweating the big stuff, potentially their largest asset base outside their owned home – their retirement nest egg – they don’t use these techniques and instead opt for way-below-par performance by overdosing on diversification and allowing themselves to be fee-fleeced by the financial establishment.
Meanwhile they are spending an inordinate amount of their time analysing and trading with much smaller amounts of money, maybe getting great percentage returns (or not), the absolute return of which pales into insignificance compared to what sweating the big stuff and marginally improving the returns on their large asset base would do for their overall wealth. And, needless to say, what it would do for their level of comfort when they eventually reach retirement.
This amazes me because these people should know better. They should sweat the big stuff… first. And then turn their attention to analysing and trading with smaller pots of money.
I have considered why people do this. I suggest that many traits of the human condition are involved to some degree; fear of making a big mistake with their nest egg, ego of potentially getting big percentage returns even though it is on a small amount of their capital, the oldest one of all – busyness on sweating the small stuff first, deferring to the social default, lack of understanding on what the cost is of not sweating the big stuff first, reluctance to take responsibility for their financial future, leaving it up to somebody else means that they won’t have to take the blame if something goes wrong.
Whatever it is, the objective of this article is to potentially ignite into action those that have their long-term retirement nest eggs invested harmfully in actively managed funds of all sorts. And thereby hopefully remove the excuse of not understanding what is being forfeited by not sweating the big stuff first and taking responsibility for their retirement nest egg before spending so much time sweating the small stuff and trading with small amounts of money.
Hopefully a bit of evidence of what they have and will continue to forfeit in lost retirement nest egg over the long term will ignite some action to step into a different process.
Over the 24.5 years since the Superannuation system started in Australia in 1992, the difference in returns between the ASX200 Accumulation index and the median return of Superannuation funds in Australia is around 2.5% compounded annual return (CAR).
Median means the fiftieth-percentile which means that half of the Super funds in Australia have done better and half have done worse than the median of 2.5% CAR worse than the ASX200 Accumulation index (Total Return index in the U.S.). The best Super fund over that period is around 1.2% compounded per annum better than the median, and the worst is about 2.5% CAR worse than the median. This means that the best is still more than 1% CAR worse than the ASX200 Accumulation index and the worst is around 5% CAR worse than the ASX200 Accumulation index.
Over short periods of time, from a few months to a few years, actively managed funds, Super funds and balanced funds can do better than the stock market Accumulation index (Total Return index in the U.S.) but all the evidence and research shows that the probability of just a handful beating the index over periods of longer than 7 to 10 years is very slim. What is even more slim, in fact probably impossible, is an investor of any type picking any actively managed fund many years in advance that will beat the stock market index over the long term.
In the U.S., the differential between the best performing stock market indices and the median returns of retirement investment funds, active equity mutual funds and balanced funds is even wider. Let’s look at the huge effect that small differences in compounded annual return (CAR) make over the long term.
The following table uses a 2% CAR differential between an index ETF, which tracks a stock market index, including annual management fees, and median returns of balanced active funds typical of Super funds and 401(k)s. 2% CAR is erring on the minimum as the differential is more likely to be closer to 3% CAR, or more. These figures can be applied to all countries with developed markets.
The 2% differential would typically be due to paying additional and unnecessary fees, which can range from paying an additional 0.3% to 1.5% p.a., and poorer performance, which can range from 1% to 5% p.a., due to excessive diversification over the long term into lower performing asset classes than the stock market indices.
In all cases the differential of achieving 2% CAR less means the difference between having enough for a couple to last a twenty-year comfortable, independent retirement, and having a retirement gap where money runs out well before departing our wonderful planet. If the 2% differential was between, say 5% and 7%, then the situation gets even worse of balanced fund investor.
This assumes drawing down an income of $60,000 p.a., adjusted for inflation at 2.5% per annum. Of course, if your retirement period is longer than 20 years or you require more than the inflation-adjusted $60,000 p.a. to live your chosen lifestyle, then the retirement gap will be even larger or you will have to depend heavily on your family and the government, if either can afford it. Relying on others means that you will not have attained financial freedom.
The model also assumes that your retirement nest egg during retirement will grow at 5% compounded p.a. and that inflation is 2.5% p.a. If you grow your retirement nest egg at less than 5% p.a. during retirement, say at 2.5% p.a. to match such a rate of inflation, then your nest egg will need to be 25% larger at the start of retirement.
What if your retirement nest egg is invested in the bottom half of funds’ returns, let alone achieving returns similar to the median? Indeed, performance outcomes of retirement funds is like a lottery. Choose incorrectly and decades down the track you could find yourself underfunded by more than a million dollars.
Note the column in the table above entitled % Lost to Fees and Diversification. These percentages grow dramatically if the differential is 3% to 5% CAR worse than the performance of a stock market index.
In the U.S., investing in the S&P400 Mid-cap index via the index ETF, MDY, and reinvesting dividends over twenty years from 1995 to 2015 would have achieved 11.71% CAR, despite this period including two serious bear markets in 2000 – 2002 and 2007 – 2009. This is around 4% CAR better than the average returns of balanced mutual funds, including target date funds, where the majority of Americans’ retirement money is invested. In Australia, 75% of the population’s Super is invested in balanced funds.
The variables that you have at your disposal to make achieving financial freedom more certain are:
Save more than 9.5% of your salary every year into your retirement nest egg during your working life.
Earn more to ensure that 9.5% annual saving increases in absolute terms.
Invest better during your working years.
The easiest variable to control is the third option – invest better. Every working person who contributes to a retirement fund of some sort is, by default, an investor. What most do with their retirement nest egg is use the ostrich strategy and hand it over to a balanced fund.
The path of action is to achieve a predictable first place in the investing stakes and invest on a buy-and-hold basis in index ETFs (Exchange Traded Funds) which have annual fees in the order of half to twenty times less than active funds and which outperform nearly all balanced funds of all sorts over the long term. Invest all retirement contributions and dividends in the index ETF.
Those that wish to improve returns even more, another 2% – 5% CAR, and protect their nest eggs from large drawdowns during severe bear markets can apply technical techniques to conduct near-passive low-effort timing on these index ETFs.
Gary Stone is the author of Blueprint to Wealth: Financial Freedom in 15 Minutes a Week, where the research to back-up this article and what to do about improving retirement nest eggs can also be discovered.
He is also the CEO of Share Wealth Systems.