Burton Malkiel, author of the perennial best-seller “A Random Walk Down Wall Street,” is unequivocal in his belief that an investment strategy must be linked to a person’s life-cycle. As he points out, “it is simple common sense to say that a thirty-four-year-old and a sixty-four-year-old, saving for retirement, may prudently use different financial instruments to accomplish their goals.”1
Malkiel believes that people at completely different stages of their lives may well have investment portfolios which consist of the same types of assets. In other words, both his thirty-four-year-old and sixty-four-year-old investor may have a portfolio made up of shares, bonds and property. However, as we will see, the mix (or weighting) of each category is likely to be very different.
Not that the type of asset chosen is unimportant. According to Malkiel, the most important decisions an investor will ever make concerns the asset types chosen, and the balancing of those asset types in a portfolio at different stages of their life.
Roger Ibbotson of US financial consulting firm Ibbotson Associates confirms that more than 90% of an investor’s total return is determined by the asset categories that are selected, and their weighting in the investment portfolio. Less than 10% of investment success is determined by the specific shares, bonds, money market deposits etc. that an individual chooses.
Before discussing the way in which portfolios should be constructed at different stages of the life cycle, we need to consider Malkiel’s four key principles that must be borne in mind when making asset allocation decisions:
1. History shows that risk and return are related.
2. The risk of investing in shares and bonds depends on the length of time the investments are held. The longer an investor’s holding period, the lower the risk.
3. Rand-cost averaging can be a useful technique to reduce the risk of stock and bond investment.
4. You must distinguish between your attitude toward and your capacity for risk.
We will examine each of these principles in turn, as the implications have a significant bearing on asset selection and weighting at different stages of the life cycle.
The relationship between risk and return
Although it is almost a cliché that you can only increase your investment returns by assuming greater levels of risk, it remains one of the great truisms of investment management. What is more, it is backed up by centuries of historical data. For instance, between 1926 and 2001, NYSE-quoted US large company shares provided an average annual return of 10.4%. This was well above the return of 5.4% earned by long-term corporate bonds during the same period. However, total returns from shares were negative in about three years out of every ten, a reminder that greater returns are invariably accompanied by greater levels of risk. Although this data is based on US markets, a similar trend can be observed on the JSE. Anyone who has followed world stock markets will know the truth of the saying that: “When New York sneezes, the rest of the world catches a cold.” The JSE tends to move in lock-step with the NYSE, so that US stock market trends (if not actual returns) are likely to be replicated to a very large extent by the JSE.
Your actual risk in share and bond investing depends on the length of time you hold your investment.
The length of time that you are able to stay invested in a particular asset plays a critical role in the amount of risk you are exposed to. To illustrate this, let us take the example of a twenty-year R1000 government bond paying 5% interest per year. (Bonds are used by governments and large companies as a means of borrowing money, and are known as fixed income securities. So, in the example above, if you hold the bond for the full twenty years you can be guaranteed interest payments of 5% per year (i.e. R50 per year), and a refund of your R1,000 after twenty years. Of course, ‘guaranteed’ may be too strong a word. However, in financial circles a government bond is regarded pretty much as a ‘risk-free’ investment, while corporate bonds are acknowledged to carry more risk).
You do not have to hold a bond until its maturity date. Let us assume that you have to sell the above-mentioned bond after three years, at which time bond interest rates have risen, say, to 6%. Anyone buying your bond would then want a 6% return as well, which means that they would only be prepared to pay R833 for the bond. (Remember, your bond pays a fixed interest amount of R50 per year. At a price of R833, R50 per year represents a 6% return). You would therefore make a capital loss of R167 were you to sell your bond after three years, and no loss at all if you held it for twenty years.
Of course, should interest rates fall your bond would increase in value. The issue, however, is that risk is eliminated by holding the bond to maturity, while selling before maturity introduces risk into the equation.
What about stock market investments? Does a longer holding period reduce the level of risk? The answer is yes. History shows that a substantial amount (but not all) of the risk of share investments can be eliminated by adopting a policy of long-term ownership, and sticking to it through thick and thin. (In other words, by utilising a buy-and-hold strategy).
As mentioned previously, between 1926 and 2001 the NYSE produced an average return of 10.4% per annum. However, in one year the rate of return was over 50%, while in another it was negative by more than 26%. It is clear then that stock market investors cannot rely on an adequate rate of return in any single year.
The picture changes considerably though if you hold on to your shares for 25 years. Referring again to the US stock data, while returns vary depending on the exact twenty-five year period chosen, the variability is not large. If you had happened to invest during the worst 25-year period since 1950, your return would have been about 3% below the long-term average of 10.4%. According to Malkiel, it is this fundamental truth that makes a life-cycle view of investing so important. The longer the time period over which you can hold on to your investments, the greater should be the proportion of shares held in your portfolio. Malkiel goes on to warn that favourable returns from the stock market are only achieved by buying and holding a diversified portfolio of shares. Switching investments around in a futile attempt to time the market will only benefit your broker and the tax man, and will result in a poorer net performance.
It is also a reality that, the longer an individual’s investment horizon, the more likely it is that shares will outperform bonds. In any one year there is a one-in-three chance that bonds or money market funds will outperform shares. But, if one examines different twenty or twenty-five year holding periods, shares are the performance winners every time. This suggests that younger people should have a greater proportion of their money in shares than older people.
The biggest reason why older people should be more conservative is that they have fewer years of labour income ahead of them. They can’t rely on salary income to sustain them if the stock market has a period of negative returns. A steadier (even if smaller) return from bonds would be preferable, and investments in equities should therefore represent a far smaller proportion of their portfolios.
Rand-cost averaging can reduce the risks of investing in shares and bonds
If, like most people, you will be building up your investment portfolio over time by making small purchases at regular intervals, you will be taking advantage of rand-cost averaging. The technique does have its critics, but it does help you avoid putting all of your money into the stock or bond market at the wrong time.
Rand-cost averaging occurs when you invest the same fixed amount of money at regular intervals – say monthly or quarterly, in, for instance, a unit trust fund. It is essential that, no matter what is happening to the stock market, you continue to invest in both good times and in bad. The effect is to ensure that the average price at which you purchase shares is below the average price of those shares for the period of investment. This occurs because you are not buying the same number of shares per month, you are investing the same amount of money each month. As a result you buy more shares when prices are low, and fewer shares when prices are high.
You must distinguish between your attitude toward and your capacity for risk.
Malkiel emphasises that capacity for risk and attitude toward risk are two different things. Attitude toward risk is determined by a person’s personality, with people being inclined (in varying degrees) either toward a risk-taking or risk-averse attitude. However, even someone who is a natural risk-taker can at certain times have a low capacity for risk.
We can illustrate this by considering the case of the two investors introduced at the beginning of this article. At thirty-four the younger investor has a much greater capacity for taking on risk. He or she is likely to be entering the peak years of salaried earnings, and as a result is far better able to cope with possible investment losses. These can be made up over time, and because of the availability of salaried income there should not be a need to dip into invested capital, or rely on earnings from investments for day-to-day living expenses.
The sixty-four-year-old is in a far more vulnerable position, however. In his or her case, salaried earnings are likely to dry up in the not too distant future. Invested capital must be preserved at all costs, and as a result the older investor has a far lower capacity for risk than their younger counterpart. As we will see, capacity for risk is an important determinant not only of the assets to be included in a life-cycle portfolio, but of the weighting thereof as well.
Life-cycle portfolios
In compiling their portfolios, Malkiel recommends that people make use of low-cost unit trust funds for all asset types. This is because most people do not have sufficient funds to diversify properly, and are also likely to be building their portfolios by way of monthly instalments. He also recommends four different asset types: (His recommendations have been adapted to suit South Africans).
• Shares: Broad-based JSE-listed share trusts (including smaller growth companies), plus a mix of international share trusts (including emerging market funds).
• Cash: Money market fund or short-term bond fund (average maturity 1.0 to 1.5 years).
• Bonds: High grade bond fund.
• Real estate: Property fund
The suggested weighting of assets in the various life-cycle portfolios is as follows:
The type of unit trust funds you choose will depend on your personal risk profile. If you are not familiar with the various South African unit trust funds (which include international and emerging market funds), you might find a publication such as Profile’s Unit Trusts and Collective Investments very useful. It is published every six months, and is a comprehensive guide to SA unit trusts and their performance.
In years gone by, people worked for one company for fifty years and retired with a good pension. In the post-credit crunch era, many employees nearing retirement are faced with the reality that their company pension funds are bankrupt, or at best are seriously under-funded.
Burton Malkiel has made it clear that we can achieve investment success with a relatively simple strategy. The secret is to start early, and to stay with the programme. Retirement may then be a lot less painful than if you depend solely on the people you work for.
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1. Burton G. Malkiel (2003). A Random Walk Down Wall Street, 8th Edition. Published by W.W. Norton and Company, New York.