These two approaches are hotly debated and have sparked a rivalry with more punch than Senna vs Prost. Yet, there is a third approach that attracts far fewer column inches and it could leave you better off in the longer term.
Why are pensions invested?
Before we get into the different approaches to investing, it’s worth looking at why investing is so important when it comes to your pension savings.
Investing is a way of increasing the value of your savings over the longer term. This is important as we continually fight to counter the effects of inflation. And especially with something like your pension, you want to grow your money as much as possible to help you live the kind of life you want to even when you are no longer receiving a steady income.
In very simple terms, the more risk you are prepared to take with your investments, the more you could get back. But also, the more you could lose. And if your pension is going to be one of your main sources of income in retirement, then it’s unlikely you can afford to take too much of a risk.
So, pensions tend to be invested in different ways, each with a different level of risk. From stock markets, where the value of your investments can go up and down a lot in the short term, to bonds, which tend to be much steadier, although the potential returns are generally lower compared with stock markets. On this page we primarily talk about stock market investment strategies.
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Stock markets are where lots of different shares from companies all over the world exist. When your pension savings are invested in stock markets, your money is used to buy these shares. If you own a share it means you own a small part of a company and you receive a proportion of the profits that company makes.
The shares you own go up and down in price. And almost anything can make that happen, which makes predicting what will happen next to a share price very difficult. It’s these swings in value over very short periods of time that make stock markets so potentially powerful, and volatile.
What is the traditional way of investing in stock markets?
The traditional way of investing in stock markets is what we’ll call investment herd one. It’s by far the most common approach and it’s built on a belief that we can predict the future.
The premise is simple enough: investment experts research stock markets thoroughly and then invest their clients’ money based on which company shares they think are going to go up or down in value.
While there are some notable success stories out there, the question is: would you be happy for your pension savings to be invested based on what is essentially guesswork, however educated that guesswork may be?
Less than a quarter of these types of investors achieve their goal of outperforming the market.1
What is an investment tracker?
If you take a step back and look at the history of stock markets, you will see that they have always gone up over time. When some inquisitive scientists realised this in the 1970s, they also realised that the solution was to invest your money in all markets and leave it there to grow over the longer term.
This has led to the creation of tracker funds, which, broadly speaking, are how investment herd two works. Is it an approach that aims to replicate the performance of a specific slice of one stock market. For example, if you invest your pension in the FTSE All Share tracker fund, your savings are used to buy shares in every one of the 600 companies that make up the FTSE All Share index (which is a specific slice on the London stock exchange).
Compared with investment herd one, there are three standout advantages:
Having said this, the investment tracker approach has two key limitations:
- By investing in a tracker fund you are still restricted in terms of the shares you can buy
- Tracker funds have to make trades at specific times of the year and this reduces potential performance
Why is investor discipline so important?
The third approach to investing picks up the reigns from the tracker herd. It uses discipline and technology to drive down costs while increasing potential returns. It does this in three key areas:
- Investing in stock markets globally, rather than just a specific index
- Using technology to make small gains every time you trade, which is often
- Avoiding market elements that consistently carry higher risk, such as companies that are new to the market
The aim of this investment strategy is more often than not the investments you make will beat the average market return by a small yet significant amount.
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1Active or Passive investment, Which? April 2018.
2 FT Adviser, Round one, active versus passive (October 2018)