Lifecycle investing will deliver a relatively higher return given the elevated allocation to riskier assets until middle age after which a more conservative asset allocation approach is taken. This may be appropriate for some, but not for many investors as they need to manage their ‘longevity risk’
Investing for a peaceful retirement life is a matter of intense concern to billions of people across the globe. Conventionally, younger individuals should invest a significant part of their savings in riskier assets such as equity whereas when they become older, they should invest more in safe assets such as government bonds. This is based on the concept of lifecycle investing. Whether this concept holds good in today’s context and what is the darker side of this investment strategy, let us discuss below.
Concept of lifecycle investing
The above theory is based on the assumption that every investor has two kinds of wealth—financial wealth and human capital wealth. The financial wealth, which is most familiar to us, is held in the form of assets such as currency, bank deposits, equity shares, bonds, real estate, insurance, mutual funds, etc. The other type of wealth is human capital which is nothing but the value of all expected future income from working. So, total wealth is the sum of financial wealth and human capital.
Human capital is less risky
Human capital usually constitutes a large fraction of total wealth for younger investors and so the ratio of human capital to total wealth decreases as the individual ages until it reaches zero at the point of retirement. Thus, this theory assumes that human capital is less risky compared to financial wealth for most individuals.
Weakness of lifecycle investing
A theory is practically useful only if its underlying assumptions are valid and logical. Unfortunately, the underlying assumptions of lifecycle investing theory may not necessarily hold true for many individuals. For instance, a person’s welfare depends not only on his/her end-of- period wealth but also on the consumption of goods and leisure during his/her entire life span.
Similarly, for investors with risky human capital, such as entrepreneurs, this concept of investing may not fit. For them, the optimal path may be to start out early in life with no stock market exposure in the investment portfolio and increase the exposure as age goes up.
The value, riskiness, and flexibility of an individual’s labour earnings are of utmost importance in optimal portfolio selection at each stage of the lifecycle. Once the standard assumptions of human capital risk and labour flexibility are shown not holding true for an individual, we need to assess whether the lifecycle investing approach still has
Lifecycle investing undoubtedly will deliver a relatively high expected return given the elevated allocation to riskier assets until middle age whereas on reaching the age of retirement this approach will dictate a more conservative asset allocation. This might be appropriate for some, but not for many investors as they need to manage their ‘longevity risk’ meaning which is the risk of outliving their money.
To conclude, technically lifecycle investing reduces the probability of taking a big loss when you are very close to your goal. Investors practise lifecycle investing for many decades. However, they need to pay attention to the dark side of the concept also.
The writer is professor of finance & accounting, IIM Tiruchirappalli