We previously reviewed how an individual’s risk tolerance impacts investment behaviour.
While risk tolerance is a driver in one’s investor profile, so too are an individual’s unique personal circumstances. Where an individual is at different stages of one’s life greatly influences the risk/return decisions that are made.
Today we will review the Life Cycle view of wealth accumulation. It does not address all the unique issues facing you, but moves us in the right direction to create an effective investment plan.
Accumulation Phase
Accumulation occurs early in your career. When you initially enter the work-force and for the first few years afterward.
Because you are young, there is a long time horizon for investing. Time is extremely important. The longer money is invested, the reinvested income on that money actually contributes more to total growth than most other factors.
Although you are finally earning real money and have the capacity to begin saving, your net worth is likely quite small. It may even be negative if you have significant debt from student loans, home mortgage, or car loan.
During this phase, your priorities may be liquidity for emergency funds, paying down debt, buying your initial or larger home, starting a family, saving for your children’s education.
And yes, beginning to invest for long term growth and retirement.
While you may not have significant savings, starting to invest as early as possible is best. The longer your money can grow, especially if you reinvest the income (and the income on that income), the greater your wealth accumulation (and the less in total dollars you need to contribute).
We will cover this concept soon when we look as the power of compound returns. A very important topic.
That said, paying down existing debt saves significant interest costs. Usually being paid with after-tax disposable income. While beginning an investment program when young is useful, do not necessarily do so by not reducing personal debt.
As we shall also see later, avail yourself of any investment plans that defer, minimize, or avoid tax liability on returns. The longer assets grow for your benefit and not the government’s, the greater the ability to compound returns.
In considering suitable investments, you should focus on relatively high risk, high return, capital-gain oriented assets.
Why?
Due to the long time horizon, you have a greater probability of riding out the ups and downs of high volatility (i.e., high risk) investments that offer greater potential returns.
Consolidation Phase
Consolidation takes place during the mid-to-late stages of your career. While a lesser time horizon than in the Accumulation Phase, the years until retirement are still very long.
By now you have reduced your debt and related cash outflows to service both the interest and principal. Your income and cash inflows exceed your expenses and cash outflows.
During this phase, you should begin to generate more than sufficient savings with which to seriously invest for retirement.
As your time horizon is still long, focus should remain on relatively higher risk, higher return assets.
But as you move through this phase and the time horizon starts to shorten, there should be a progressive shift to lower risk (i.e., less volatile) investment options.
Spending Phase
Spending commences at retirement as employment or business income ceases or slows.
Your debt is gone, your children grown and not needing support, and your required expenses should not be extensive.
Without a salary, income will be derived primarily from your investments and, possibly, pension. As a result, you want to increase the certainty of your returns by investing in lower risk investments.
One mistake made in this phase is to place too much reliance on low risk investments. Low risk assets will result in low returns that may not be adequate to meet your retirement goals.
Also, if returns are not linked to inflation, you may find your real returns worse than expected. At times, even negative. If this occurs, you may be unable to meet your retirement objectives.
A second mistake is to underestimate retirement needs. Yes, you are retired and many of your work related expenses vanish. And yes, with the kids gone, the mortgage paid, etc, many other traditional costs also disappear.
But these will be replaced by increased travel and entertainment costs. Expenditures you may not have made to such an extent previously. These are not “required” expenses. But if you do not factor in these additional costs when planning, it may be a very boring retirement.
In today’s world, you could easily retire between 55 and 62, yet live until over the age of 90. That means you may need retirement income for a at least 35 years.
If all your assets reside in low risk, income generating investments, you may be hard pressed to cover all your needs and objectives until death. With a still lengthy time frame, you may want to keep a portion of your wealth in assets with higher growth potential. Then, with each passing year, continue to slowly shift into safer assets.
Gifting Phase
Gifting is the final stage in your life. Hopefully a long, long ways off for you.
In this stage, you possess more assets than you need until the end of your life.
You begin to gift your wealth to others. This may include family members, but more and more people are becoming involved in philanthropic activities. These include direct donations to charitable or educational institutes. Also, some people set up trusts and foundations with their wealth to contribute directly to their charitable objectives.
Takeaway Thoughts
One takeaway is investments that may be prudent for you in one stage of your life, may not be best in another stage.
In your 20s, it may be appropriate to invest in mutual funds of emerging markets. These funds may exhibit relatively high risk but also offer potentially generous returns. But at 80, those same funds may make little sense in meeting your retirement objectives.
Conversely, at 80, a significant portion of your wealth may be in term deposits and short-term government bonds. This may be prudent in attempting to preserve your capital and generate steady cash flow. But at age 30, having a significant portion of your assets in cash equivalent investments likely is a poor strategy to follow.
A second takeaway is that your life cycle phase is based on your personal situation, not age.
You and a friend may both be the same age. But if he spent 10 years travelling the world as a scuba instructor and has just now completed a 10 year medical program, he may only be in his Accumulation Phase in his 40s. On the other hand, you started your career at age 22 and may have moved on to the Consolidation Phase by your 40s.
Age is not a determinant. Only your personal circumstances.
Getting married and having children while in your 20s may result in a significantly different investment program than for a single person also in their 20s. Life insurance may be one big difference.
A third takeaway is that you must focus on your own unique situation. What others are doing should have little, if any, impact on your investment strategy.
When listening to investment advice or strategies employed by others, always consider their personal situation and how it compares to your own before following their lead.
For example, a German friend tells you about a great potential real estate investment in Saskatoon, Saskatchewan, near where you live. The local market is hot and everyone believes the expected gains will be excellent. For her, it may indeed be a good opportunity. But if you already own a home in the community, a rental property in the same city, and a cottage at a nearby lake, it may not be a wise move.
This is because you may end up with too much exposure to the local real estate market (if you have not already done so) and/or possibly have invested too much in real estate as an asset class in general.
That gives you a few things to consider as you begin to address your own investment strategy.
Coming up, we shall look at common investor objectives and constraints.
