Conventional wisdom says people should invest more heavily in stocks when they’re young, then shift to bonds as they age. However, some of the logic behind this wisdom may not hold up, according to a recent Regional Economist article.
Research Officer and Economist Guillaume Vandenbroucke noted that there are two oft-cited arguments for why portfolio mixes should change as people get older:
Vandenbroucke noted that stocks have historically provided higher returns than bonds, albeit with higher risk. Based on historical real returns of riskless bonds (measured by U.S. Treasuries) and risky stocks (measured by the S&P 500 Index), $1,000 invested over 20 years would rise to $1,173 if invested in bonds but $3,855 if invested in stocks.
“Clearly, despite the risk, investing in stocks seems the better choice, but who can wait for 20 years?” Vandenbroucke wrote. “The young.”
However, he noted that there were two issues with this logic. The first is that a longer time horizon also means more opportunity for stocks to drop in value, which some young people may fixate on.
“In other words, young people with a strong enough dislike for risk will view the stock market as too risky because they are young (and thus have a long investment horizon) and they are focused on the potential for disaster,” he wrote.
The second issue is that portfolios can change at any time. “This implies that there is, for all intents and purposes, no difference between a long and short investment horizon,” Vandenbroucke noted. “There’s no such thing as a ‘long’ horizon when the portfolio can be readjusted annually.”
The other argument for young people investing in stocks—that they will work longer—centers around the fact that assets aren’t limited to stocks and bonds. A person’s ability to work and earn a living—also called their human capital wealth—should be factored into the equation as well.
Vandenbroucke wrote that a person’s human capital—the value of a worker’s future income stream—decreases with age, becoming zero at retirement. “With this view in mind, a person’s wealth is the sum of his financial wealth and his human capital wealth,” he said. “The best portfolio allocation should be decided by taking into account human capital wealth and the fact that this wealth approaches zero as retirement becomes imminent.”
He gave an example of a young household that wants to split its wealth 50-50 between risky and riskless investments. Since human capital wealth for a young household is close to a riskless asset, the household should hold more stocks than bonds to achieve its target portfolio mix. “Upon reaching retirement, however, human capital wealth approaches zero, and financial bonds must be used to achieve a 50-50 goal,” he wrote. “This is a valid reason why young households should hold more stocks than older households.”
Using data from the Federal Reserve’s Survey of Consumer Finances, Vandenbroucke examined whether young households indeed held more stocks than bonds relative to older households. “The message … is that a clear pattern linking the age of the household’s head and the stock-versus-bond composition of the household’s financial assets is missing,” he wrote.
For example, households headed by someone younger than 35 held 40.2 percent of their assets in stocks in 2016. Households with heads between 65 and 74 held 50.2 percent of their assets in stocks. (For a figure showing these trends across age groups and years, see the Regional Economist article “The Role of Age in Determining Stock-Bond Investment Mix.”)
Vandenbroucke concluded: “[T]his suggests that there are determinants other than age in the decision to acquire stocks versus bonds.”