It is conventional wisdom among financial advisers that young investors should have aggressive equity allocation of 70-90% since they have longer time horizon. A long-time horizon gives young investors much needed staying power which is essential for equity investing.
While time horizon is an important factor in making asset allocation decisions and the rationale behind this advice is undeniable, there is one flaw in blindly giving this advice to all young investors just starting their investing journey. Let us discuss it in this article.
All investors whether young or old are most vulnerable during the initial years of their equity investing life. They are least experienced, have least faith in equity and possess least knowledge about the nature of equity as an asset class at this stage. An aggressive asset allocation puts them directly in confrontation with vagaries of equity market. Many times the money they are asked to put into equity is all the money they have and it is difficult for them to see their only savings wildly fluctuating in value. This makes handling aggressive equity allocation even more difficult at the start of investing journey for most young investors.
Jim Otar, the Canada based financial adviser explains this situation in his book Unveiling the retirement myth with an apt example.
“Picture this: you just have your first baby boy. His average life expectancy is 84 years. Being overjoyed, you grab the baby and start tossing him up towards the ceiling, over and over again. Everyone witnessing this dangerous spectacle in the delivery room is screaming at you, in shock. Finally, you stop and explain: “Why should I worry? His life expectancy is 84 years. He has long time horizon!” Well, not so, if you put the poor baby at undue risk.”
This is exactly what many financial advisers do with baby portfolios of young investors.
Aggressive equity allocation requires innate faith in equity that comes through experience and after putting some effort in studying and understanding it. It also demands behavioral edge. Long time horizon of young investors is not good enough reason to believe that they can handle aggressive equity allocation from the very start of their investing life. There is good possibility that some of them may get scared of market fluctuations or get discouraged if market is not in a secular bullish trend during this early phase and end up straying away from the path of disciplined investing.
In face of this danger, completely exposing baby portfolios of young investors to equity makes sense only if benefits of aggressive equity allocation justifies the risk taken. Let us see if this is the case or not.
There are three stages during accumulation phase
Seed money formation stage
Mid-life growth stage and
Pre-retirement consolidation stage
In terms of annual expenses in the first year of retirement, these three stages can be roughly divided as
Seed money formation stage : until portfolio reaches 2 times annual expenses in the first year of retirement
Mid-life growth stage : From 2 times to 20 times annual expenses in the first year of retirement
Pre-retirement consolidation stage : From 20 times to 30 times annual expenses in the first year of retirement
All young investors starting their investing journey are at the Seed money formation stage where objective is to create sufficient base for future portfolio growth. Effect of compounding is not significant at this stage.
Let us take example of a 24 year old who starts investing ₹10,000 per month which is 20% of his in hand salary. Assume that he gets 7% return in debt and 12% return in equity (5% real rate of return). Here is how his portfolio will look like during the first 5 years if we assume linear growth of the portfolio.
Year Invested Amount 100% Debt Portfolio Conservative Portfolio
1,20,000 1,24,649 1,26,014 1,27,396
2 2,40,000 2,58,303 2,63,849 2,69,534
3 3,60,000 4,01,630 4,14,614 4,28,120
4 4,80,000 5,55,313 5,79,521 6,05,057
5 6,00,000 7,20,105 7,59,898 8,02,470
From above table, we can calculate percentage of portfolio growth attributable to discipline of investing from the difference between portfolio values of aggressive portfolio and 100% debt portfolio.
Year 1 2 3 4 5
% of portfolio growth attributable to Discipline of investing 98% 96% 94% 92% 90%
Similarly, the percentage of portfolio growth attributable to aggressive equity allocation can be calculated from the difference between portfolio values of aggressive portfolio and conservative portfolio.
Year 1 2 3 4 5
% of portfolio growth attributable to aggressive equity allocation 1% 2% 3% 4% 5%
As can be seen above, more than 90% of the portfolio growth can be attributable to the discipline of investing during the first 5 years of investing. The % of portfolio growth attributable to aggressive equity allocation over conservative allocation is also less than 5% during this period.
One important point we should note here is that we are assuming linear return from equity. In real life equity doesn’t give return in straight line. Historically equity markets spent half of the time in secular bullish trend. Rest of the time markets either went down or moved in sideways trend.
Given this scenario, if it is really worth recommending aggressive equity allocation to young investors at the start of their investing journey, is a question advisers need to ask themselves. Remember behavioral risk is the highest at this stage and skipping few months of investing hurts more than potential lower return from conservative portfolio. At what rate portfolio grows does not make much of a difference in initial years of investing.
The most important element at seed money formation stage is to invest with discipline, month after month, year after year until a strong base is created for future portfolio growth. Abandoning the long term investment plan is more damaging at this stage than small benefits derived from potentially higher return.
Therefore a safer way is to begin with conservative equity allocation, reduce volatility of the portfolio and make it easier for investors to stay disciplined. Once they gain some experience, begin understanding volatility of equity markets and survive initial period, equity allocation can be increased towards target allocation.
Instead of starting with 70 to 80% equity allocation from the very start for inexperienced young investors, I would rather start with 40% equity allocation, reduce volatility of the portfolio, make them invest with discipline and increase allocation towards target equity allocation once the initial vulnerable period is survived.
There are cases where an aggressive allocation can be safely recommended but recommending it to all young investors just because they have long time horizon is not the most sensible thing to do.