Thursday, October 30, 2014

100 minus age asset allocation

Rob Arnott and Research Affiliates have written a provocative paper on the risks of following life-cycle investing. There is a rule of thumb that you should take 100 minus your age to determine your stock allocation over your life. Young people should hold more stocks and as you age you should cut your stock exposure. 

This high stock allocation for the young is the premise of life cycle funds, but there is underling this approach the assumption that you never need the money. The cash is put away for retirement. However, there is clear evidence that young people will often have to raid the savings jar because of change in job status. If you go unemployed in a recession and you need the cash for consumption, holding risk assets may not be a good strategy. In fact, if you may need the cash at the worst time in terms of stock returns. This same argument could apply if you just make job changes and you have a cash shortfall. You have to think about short-temr portfolio performance.

Stocks do poorly during a recession when you have consumption risk. This is one of the reasons why you need a premium for holding this risky asset. If that is the case, then holding more stocks when you have more employment risk is a risky investment strategy. Life cycle funds are not a solution but a problem. You might need more cash when you are young. Or, you need to hold alternatives that will do well when there are market or economic disruptions. 

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