Monday, May 19, 2008

The Relation between Age and Portfolio Risk – Counter Intuitive Results

Should young investors really hold riskier portfolios?

There is a common financial thumb rule when it comes to an investor’s age and the risk level of his portfolio. Most financial planners recommend a higher level of portfolio risk to younger investor and a lower level of portfolio risk to older investors.

This thumb rule is rooted in what seems to be common sense financial logic. A younger investor has more time left to save thus allowing his portfolio to adjust and compensate for possible loss due to the high risk level taken. And older investor should, by the same logic, avoid portfolio risk and concentrate his investment efforts on preserving his hard earned and saved capital.

Academic research is not supportive

Surprisingly enough this practical thumb rule has little in the way of academic support. I’ve been trying to find an academic justification for this professional habit and I’ve failed. Furthermore, I’ve found articles dating as early as 1970’s doubting this very logic application of finance.

Noble winning economist Paul Samuelson published an article on the subject in 1963 which is still referred to by almost any article ever since. The article was titled “Risk and Uncertainty: A Fallacy of Large Numbers”. In this article Samuelson demonstrated how having multiple draws (much like multiple years of saving) has nothing to do with risk preference.

This is understood more intuitively by thinking of the slim chance of a 20 year financial drought which might happen during all of your early years of investing in stocks.

Surprising results of a new published research

“Adding insult to injury” a relatively new research by Harold J. Schleef and Robert M. Eisinger titled “hitting or missing the retirement target: comparing contribution and asset allocation schemes of simulated portfolios" found some surprising results.

The researches simulated hypothetical portfolios for different investors and investment periods for ages 35-65. The researchers studied two strategies:

1.Strategy A - Portfolio risk declines with age – the share of stocks is reduced from 78% at age 35 to 40% at age 65.

2. Strategy B - Portfolio risk increases with age - the share of stocks is increased from 40% at age 35 to 78% at age 65.

In both strategies the methodology included an annual contribution of $11,000.

Results were indeed surprising. Strategy B where risk was not reduced with age but was actually increased with age 45% of the portfolios reached a net worth of $1,000,000 or more. Strategy A managed far worse with 29% of the portfolios reaching a net worth of $1,000,000 or more.

These results are a great way of demonstrating what Samuelson understood back at 1963. Variability is everything. Long term investments are not risk free. If they were risk free there’d be no premium on investing in stocks for the long term.

A third option that was not simulated was keeping a fixed share of stock in the portfolio for the term of investment. I assure you, a research can be put together to prove this strategy as the better one under specific conditions.

The bottom line, be reasonable. There is no guarantee in long term stock investments and they are just as risky. Don’t miss out on stock returns but don’t be blinded by them either.

Related Posts:
Long Term Investments are not Risk Free
2. How to Avoid Crippling Your Retirement Funds


Big Al said...

I have always said that the young don't even need to be risky. You can make a million by 65 starting at 18 with only a 5% return, but starting from 40 you need a huge return, which means you need huge risk. The practical fact is that you need more risk when you're older.

I, like you, don't believe you need to adjust your risk level much when you age.

Kristin said...

Interesting. Thanks. This has inspired me to go run a few monte carlo simulations for myself.

Dorian Wales said...

@big al - Very true. There's a famous simulation on a young investor saving for 7 years from 18 to 15 vs. an older investor saving for 30 years from 30 to 60. With the appropriate return rate (I think it was 10%) the older investor can't hope to catch up with the younger one. The problem is we hardly ever have the money available at younger ages. That's where our parents should come in.

@kristin - Monte Carlo is a valuable tool. It really helps in understanding the various different (and extreme) scenarios we may encounter. What I don't like about it is that the deviation and average are usually used as assumptions while these can easily change as well.

Big Al said...

I would say that Monte Carlo is the only way to go nowadays for specific situations. Too difficult to apply financial or statistical formulas to any real person's life without simplifying the model too much.

Dorian Wales said...

@Big al - I can certainly appreciate it's elegant treatment of complex financial situations. However, the critics have a few good points. See this article for Journal of Financial Planning for more: The Problems with Monte Carlo Simulation