Life cycle investing is something we all intuitively apply at some point of time but we do not fully appreciate or articulate the context of life cycle investment. Basically, life cycle investing is about tweaking your investment mix as per shifts in your life cycle investing. The normal belief in life cycle investment is that your life cycle investment goals change with time and therefore with stages of the life cycle investment, strategy also needs to change. Take a simple example, your risk capacity is much higher at 25 than it is at 55 and your risk capacity has to determine and drive your investment mix.
Concept of life cycle investing
The concept of life cycle investing is basically linked to your age and your stage of the life cycle. Your risk appetite and risk capacity is more when you are a bachelor than when you are family man and it reduces when you children grow up and you have fewer years left to retirement. The normal thumb rule is that your investment mix should follow the (100-age) formula for asset allocation. How does that work. For example, if your age is 25 then 75% (100-25) must be allocated to equities. On the other hand, if you are 55 years of age, then just about 45% (100-55) must be allocated to equities. While this looks very simple and elegant there is no real scientific basis for this classification. You obviously need to consider factors beyond age for your life cycle investing.
Paradox of life cycle investing
When it comes to life cycle investment, there is a very important paradox that you need to understand. What exactly is this paradox? When you are 25 years old, you technically have a high risk capacity and risk appetite. However, that is when you have just started earning and your income levels are still stabilizing. You can start early and build a great corpus but most of your income goes in consumption. When you are 55 years of age, you have reached high levels of income but your life cycle dictated that you should be more conservative. Therefore, even with higher income levels, you are not able to put your higher income levels to productive use. How to address this paradox?
Three ways to address this paradox of life cycle investing
This is a real problem that most investors face in lifecycle investing. When you have the risk appetite and the risk capacity, your financial resources are limited and when you have the resources your risk capacity is limited by age. There are 3 ways to overcome this paradox.
Systematic investing or an SIP approach is the first way to solve this paradox. In a systematic approach you start a small SIP on an equity fund at an early stage. The advantage is that even a small corpus or small regular investment can grow into a large corpus over a longer period of time. In fact, time is such a powerful factor in long term systematic investing that even a small investment done regularly for a longer period is a lot more potent and productive than a large investment done at a later stage. Consider the table below:
SIP of Rs.5000
SIP of Rs.10,000
SIP of Rs.15,000
SIP of Rs.20,000
Tenure of SIP
CAGR on Equity Fund
Corpus Value at 55
Of course, the SIP is the most scientific approach to address the paradox of lifecycle investing. Another way is to tweak your definition of risk. Consider other factors. For example, if you are 50 and you should be ideally having a higher proportion on debt, then look at other factors. For example, if your son’s education is taken care of, if your retirement is taken care of and if your loans have been repaid, then you don’t have to really worry about your age. Your risk appetite is much higher despite higher age. You can actually put equity investing into much better use.
This can actually be a double edged sword. How do you borrow and invest. In India you can get loans against assets at lower rates but personal loans cost about 18%. To consistently earn above that would mean a tough task. Abroad, loans are a lot cheaper so this becomes simpler. But in India you have to use this more carefully.
The bottom line is that there is logic to life cycle investing but there is also a paradox. How best you address the paradox will determine how best you can actually create wealth over your life cycle.