The cost of short-sighted investing

Defined Contribution plan participants know retirement is a long-term goal, but sometimes their investment decisions can be shortsighted. With easier access to real time investment information, participants can see every zig and zag in the financial markets and watch their account values change daily.

Unfortunately, this can lead to reactive, short-term investing, or a follow-the-pack mentality. As evidence, during the global financial crisis (October 2007 to February 2009) $208 billion flowed out of equity funds in the last 12 months of the downturn. Then, from March 2009 to December 2013 $161 billion flowed into equity funds during the last 12 months of the rebound. The sellers likely sustained losses, and the buyers probably missed participating in a significant part of the upswing.

It's tough to get participants to think long term because in recent years they've mostly seen the market go up. Many either don't remember or, in the case of younger participants, have never experienced losses like we saw during the global financial crisis. Participants want to avoid excessive losses, but they often lack the knowledge it takes to identify effective risk management. To catch good performance, they might be choosing higher-risk funds than they realize. That's why it's so important to look beyond the current bull market — perhaps back 10 years or more — when evaluating DC investment options, to see what funds have done through full market cycles.

To invest more appropriately for their long-term goals, participants need funds managed along the same lines — with a longer view and an eye toward risk management. It isn't just about managing through a market decline. We believe DC funds must also lower volatility, because it diminishes the rate at which an investment grows over the long term and significantly reduces the power of compounding.

Volatility has a very real mathematical impact on returns. Consider an investor with a $100,000 portfolio that experiences a -15 percent return this month and a 15 percent rebound next month. While the average return is zero, the painful math reduces that portfolio's value to $85,000 with the 15 percent drop and raises the value to $97,750 with the 15 percent rebound. The $2,250 loss incurred is called "volatility drag," and for those nearing retirement, it's nearly impossible to undo the damage.

Funds without active risk management may seem less expensive to buy — due to lower fees — but they can become more expensive to own when the market turns south and they follow suit. That's why, with so much emphasis on fund fees lately, it's important to consider these costs in context when evaluating DC options. Cost certainly matters, but a fund's ability to provide steady growth and align with participants' long-term retirement goals should matter more.

Changing participants' behavior is a challenge, especially when you have market forces, information, and emotion as opposing forces. But it's essential to participants' ability to retire on time. If you want your participants to think and act long term, you have to offer them investment options committed to doing the same.

Ryan Mullen's comments, opinions and analyses are for informational purposes only and should not be considered investment advice or a recommendation to invest in any security or to adopt any investment strategy. Comments, opinions and analyses are rendered as of the date given and may change without notice due to market conditions and other factors. This material is not intended as a complete analysis of every material fact regarding any market, industry, investment or strategy.

This content is directed at investment professionals only.

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