Monday Morning: Allocating assets? Try latest tools

How much should a 45-year-old investor have in equities?

One rule of thumb I have heard quoted says to subtract the investor’s age from 100, and the remainder, 55 in this case, is the percentage they should have in equities. Others have said the proper formula is 110 minus age, meaning that 65% would be the correct allocation to stocks for a 45-year-old.

Few financial planners or investment advisers worthy of the name would rely on such crude rules of thumb to decide how much a client should have in equities.

Many, however, use quantitative models similar to those used on the investment advice websites, such as financialengines.com. Those quantitative models generally combine Monte Carlo simulations with Markowitz’s mean-variance efficient-portfolio diversification.

lag is noted

Zvi Bodie, professor of finance at Boston University, says practitioners in general are lagging far behind the latest in financial theory. And financial services providers also are missing the boat.

The latest developments weave together such important features as changing investment opportunities, the unpredictability of the investor’s labor income, the changing balance between the desire for goods and leisure over time, and transaction costs.

They also take into account habit formation, lack of knowledge, faulty logic and biased statistics – which lead people to consistently make certain mistakes.

In addition, dynamic programming and contingent-claims analysis are used to determine risk, while capital market expectations are derived from the current prices of financial instruments such as futures, options, swaps and interest rates rather than from historical returns.

Further, the development of the futures and options markets, and inflation-indexed government bonds such as Treasury inflation-protected securities, has provided new investment opportunities. Combined, those developments offer the potential to better match investors’ investments to their needs and appropriate risk levels.

A decade ago, Mr. Bodie, along with Nobel Prize-winning economists Paul Samuelson and Robert C. Merton, developed a theory of life-cycle finance which noted that individuals start out with an initial endowment of financial wealth and earning power, also known as their human capital.

Human capital is earning power multiplied by future years of employment.

At each point in time, individuals determine how much of their financial wealth to invest in risky assets and how much of their labor income they will “spend” on leisure.

Most experts say individuals should reduce exposure to equities as they age. The model suggests why that is so, and it’s not because the risk of investing in equities declines the longer you hold them.

The amount in equities should decline with age for two reasons. First, at the beginning of an individual’s career, the value of the human capital (present and future earning power) usually is a large part of total wealth, and financial assets are a small part.

Human capital generally is less risky than equity. Therefore, a high proportion of financial wealth can be in risky assets. But as the value of the human capital (that is, the low-risk part of the total portfolio) declines because the future working years are declining, the financial assets become a larger part of total wealth.

To keep the overall risk at an appropriate level, the amount in equities should decline.

In addition, at any given age, the greater the flexibility of the individual to increase their future earning power, e.g., by attending graduate school or otherwise upgrading skills, or by deciding to work longer, the more that individual can invest in risky assets. Younger people have more opportunity to make such changes.

different flow

But some people have human capital that is more risky than others’, such as entrepreneurs and stockbrokers. Maybe they should start their careers with little equity exposure and increase it if they are successful and build significant financial wealth.

Those insights, combined with the insights available from the new vehicles in the financial markets such as options and swaps, and the use of new vehicles such as inflation-indexed bonds, long-term index options and equity-participation securities – such as convertibles – can offer greatly improved asset allocations for investors at different stages of their lives.

And with a little demand from the financial planning community, financial services companies could develop a new generation of investment vehicles using futures, long-term index options, Tips, etc., to meet the needs of investors.

Mike Clowes is the editorial director of InvestmentNews and sister publication Pensions & Investments.