Balance Risk and Age: Lifecycle Investing
Your age impacts heavily on the type of investments you need to be making. For example, an ordinary UK investor in his twenties is much more able to withstand losses from an investment strategy because he can spend the next 40 years earning more money from his day job.
In contrast, when an investor hits retirement he’s much less able to use alternative cash flows to make up for rash investment decisions. Thus capital preservation becomes his priority. The same investment product can look completely different to investors of different ages.
The central insight of the trade-off between age and risk (known as lifecycle investing) is that age affects tolerance to risk.
Over the life of an average investor, the appetite for risk (and return) evolves. As their tolerance of risk changes, so too does their choice of assets. They move from an interest in shares and no bonds, via a period shifting away from shares into some bonds, to a bias towards bonds in their later years.
As a young investor
Imagine that you’re 20 years old and have just landed a great job working for a large multinational. You’re earning enough money to put aside £100 a month in a fund that you plan to stick with for the next 40 years of your working life, but for now you want lots and lots of growth in your underlying investments.
Therefore you’re willing to take on some risk now, and the long-term data on returns suggest that the riskiest, most rewarding of the major asset classes are shares. Bonds, by contrast, are a bit boring and safe; although you probably won’t lose more than 20 per cent in any one year (called your maximum drawdown), equally you’re never going to bag anything that makes your fortune.
In summary, as a thrusting young buck you quite sensibly decide that your risk tolerance is high and that you want to stack up on equity exposure and ‘go for it’ in terms of risk.
As an investor nearing retirement
Flash forward 40 years. You’re now a considerably older 60 year old. Retirement is only about five years away, and so you need to accumulate a large pot of savings capital to last you through to your twilight years (you may well live until you’re 90 if current longevity studies are right). Therefore, capital preservation is all-important to you.
You absolutely can’t afford a capital loss or drawdown of something like 20 per cent in one year — and so you have a very negative view of shares and are a very big fan of bonds.
As a retired investor
Curiously, when the typical investor retires, the consensus on the ‘correct’ investment balance becomes a little muddier. On paper, retirees should be ultra-cautious — they have to preserve their pension pot for a retirement that may last 30 or more years. But they also require an income to live on and the assets with the safest profile — bonds and government bonds or gilts — tend to pay the lowest yield.
Pensioners have to be cautious about the major risk of inflation. Sticking all your money in conventional bonds in high inflationary times may mean that you preserve your nominal (before inflation) returns, but the real value after inflation may be diminishing rapidly.
Why? Because when you buy a government security that promises to pay £100 back in five years’ time with annual interest of 4 per cent per annum, that’s all you get even if inflation is romping ahead at 10 per cent per annum.
In five years’ time £100 may be worth as much as £160 (that’s five years of 10 per cent inflation) but you still only get your £100 back.
Some academics and economists reckon that pensioners should be willing to take on extra risk, grow their income and increase the capital value of their investments. In this case, retired investors can consider taking on a little bit of extra risk via shares, and especially those shares that pay a dividend. Another good idea may be to reduce their bond exposure.