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Asset Allocation – Has no secret formula

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A retired civil servant of my acquaintance called recently. An honest man, he didn't take money or favours while in service. His only major asset is his membership of a co- operative housing society. Now on the verge of 70, he is completely retired and lives in that co- op flat. It has multiplied in value and on paper, he is quite wealthy.
 

In practice, he is cash- poor and worried. His pension allows him to maintain his current life style but with little to spare. Inflation over the past three years has eroded the value of his pension and it will soon become inadequate. He is in decent health and could easily end up in poverty in extreme old age.

If he sells the flat and moves to a cheaper place, he will generate some surplus cash. He must invest the surplus intelligently to beat inflation. One of his ex- colleagues had suggested that he park some of that in equity. He has never touched stocks. This was what he wanted to discuss.

After some discussion, I told him the truth as I see it: "If you invest sensibly in the stock market, you will probably earn excellent returns over a 5- 7 year period or longer. You have to be braced to forget about the money for at least 3- 5 years. There is a small chance you will go bust. There is also asmall chance you will earn massive returns very quickly. You must be mentally prepared for those extremes. If you think youll live till 75- plus, without needing to touch the surplus funds, invest a proportion of your funds in stocks. If you dont want the stress, or the risk, invest in debt. Your money will lose value, but youll probably have enough to last out your lifespan." This is a classic problem from life cycle investing. The underlying assumptions are simple enough. Stocks are risky and volatile. But in the long run, they beat inflation and outscore other instruments. Debt is safe, but loses out to inflation in the long term.

If you start a financial portfolio early in your career and hold it through retirement and beyond, your asset allocation should change to reflect your age and risk tolerance. In the early years, the portfolio should be heavily weighted in favour of equity. This gives a better chance of getting high returns without suffering from volatility.

As you grow older, the equity component should decline and debt should play a larger role. One of the dangers for an elderly person holding a lot of equity exposure is that he or she may need to liquidate it for ready cash in the middle of a bear market. In that case, the savings may be wiped out by a temporary downturn.

The life cycle investing concept looks logical in theory. In practice, it is a messy, "fuzzy" process deciding the ideal asset allocation levels. Different people have different risk tolerances and different aspirations. One size doesn't fit all where asset allocations are concerned.

Nobody knows how long they will live and this is also important when fiddling with asset- allocation. If you switch over to debt too early, you may end up cash- poor in your last days. If you hold onto equity too long, you may be hit by emergency medical expenses and forced to accept capital losses.

Average life- expectancy tells you little about personal life expectancy. Specifics like genetic make up and lifestyle play a big role. Life expectancy statistics are skewed downwards by infant and child mortality, and because young adults are more likely to die in accidents, or violent incidents.

You may be very lucky if you started investing in 1991 or 2003 just before the market went into a long bull run. You may be unlucky as well. If you started investing in 1994, the equity returns would have disappointed until 1999. Again, there was a big bear market between 2000- 2005. Somebody intending to down shift equity allocations in that period would have had to bear losses, or defer his plans.

Techniques like systematic investment plans can reduce the negative effect of such long term trends. But they don't mitigate those effects completely. Even in the very long- run, volatility has some effect on returns and that effect may be beneficial or negative.

Life- cycle investors must also tackle a tricky set of problems when changing asset allocations. When you decide to increase or decrease equity exposure, should you do it at one shot? Or should you do it, systematically, reducing exposure a little, month by month? These are important details you must work out yourself depending on your personal risk tolerance.

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