Conventional wisdom suggests that developing an investment plan for young investors should start with a heavy allocation toward equities as they have more time than their older counterparts to see their investments grow and weather bad economic storms. But evidence suggests that this strategy may not be wise or even relevant anymore.
Young adults today are establishing their financial self-reliance, starting families and saving for a down payment for their first home while often being burdened with paying off their substantial student loans. As a result, they have different savings incentives compared with clients further along with their careers. That’s because their savings are aimed at offsetting income uncertainties. So, considering this situation, should young investors have high-risk equities portfolios early in their savings cycle?
Recent research shows that young investors cash out of savings plans to meet basic living expenses — and particularly because of a job loss. Additional research shows that these young investors are more prone to job loss than older workers as the average unemployment rate for those aged 20 – 24 years old is 10% vs an average unemployment rate of 4% for workers older than 45 years of age. Moreover, the young adult’s job security is also highly correlated with the business cycle — and recessions usually follow a period of stock market downturn. This is important because young investors are more likely to be laid off during this downturn and may have to cash out their savings at this point. And if their portfolios were heavily weighted toward equities, their investments may have been reduced drastically by the correction in the market.
However, some financial advisors subject our newest investors to the highest risk by using “100 minus your age” as a percentage allocation to equities under the notion that the young can bear more risk than those of us who are middle aged. Academia further advanced this theory, stating that as we age, we should replace our diminishing human capital with bonds. But other experts consider human capital more like equities: driven by employment income, which typically grows at the rate of inflation and with ever-rising uncertainty as we look farther into the future This more closely correlates with young adults’ income streams and demonstrates they have plenty of risk already, but on the positive side as they have higher value of future earnings than older workers
Another assumption is that the young are tolerant of risk and that, as retirement approaches, the average investor becomes increasingly intolerant of downside risk. Nevertheless, many investors of all ages moved out of stocks after the collapse of 2008-09. Are these young investors likely to become risk-allergic — let alone risk-adverse — if this first major foray into the capital markets ended with a greatly reduced portfolio value, a job loss, and a further need to liquidate their savings portfolios?
So, what’s an appropriate investment strategy based on this young investor’s risk profile? Rob Arnott, chairman and CEO of Newport Beach, Calif.-based Research Affiliates LLC, recommends that young investors should not have high equities allocations in their investment portfolios until their portfolios reach a certain minimum balance of six months’ income. He considers this starter portfolio as a rainy day fund to reduce the risk of the young saver’s primary income, which has been likened to high-risk stocks.
This portfolio could be invested one-third each in mainstream stocks, bonds and diversifying inflation hedges (such as hard assets and commodities, which do well during periods of inflation whereas equities and bonds perform poorly) vs up to a 70% average equities allocation in the growing popular target-date fund (TDF) products that start young investors with a heavy equities allocation and slowly shift their portfolio holdings into bonds as they age.
Arnott suggests that by the time the balance in the portfolio meets the minimum amount, these clients will be familiar with the fact that the best investments involve some risks and will fall from time to time — and they will also be confident that they are reasonably well covered for a rainy day. These young investors can then start loading up allocations to more risky asset classes in the amount exceeding the starter portfolio minimum balance.
From this analysis, we see that not all young investors should have the conventional risk profile. So, we need to realize that they have risk in their human capital. This is their uncertain work income, which is susceptible to the business cycle and potential job loss. Furthermore, they use their early savings as a rainy day fund to offset these income cash-flow risks — and their risk tolerance needs to be shaped so that their attitudes about investing and risk bearing are not poisoned by a bad early experience.