Tuesday, April 27, 2010

Age As Proxy For Risk

A while back Andrew Stevens seemed somewhat perplexed with using age as a proxy for risk when investing. Every once and a while this pops back into FLG's head, and he's always confused.

FLG assumes that there's some sort of mathematical function that takes years until retirement and years 'til end of expected life span as inputs and can produce some optimal strategy that maximizes expected returns while minimizing risk (which is presumably represented as the variance of the portfolio). It's probably a complicated piece of stats, algebra, and calc, but seems possible.

Doesn't that make age the primary independent variable?

PS. On a completely unrelated topic, Andrew, how's the baby?


Andrew Stevens said...

Perplexed is the wrong word. In that comment, I said that I understood why they defaulted to age, but that it assumes a "normal" wealth path. If you're following a "normal" wealth path, then age is the dominant independent variable and conventional wisdom is okay.

But the other independent variables are wealth and desired lifestyle. Let us imagine, for the sake of argument, that somebody walks up and gives you $3 million. Doesn't this radically alter your risk tolerance even though you're not any older? (If it doesn't, then it must be driving up your desired lifestyle or driving down the number of years you intend to continue earning.) If you take only small risks with the $3 million, then it's probably already enough to sustain your current lifestyle for the rest of your life. There are very good reasons that you would suddenly become much more risk averse; you already have enough. (If you desire more than $3 million at retirement, adjust upward appropriately.) Whereas currently, you have to take risks with your money in order to grow it into a substantial nest egg.

Think about it another way: if someone gave you $3 million, but told you that you couldn't touch it until you're 65 and you have to make all of the investment decisions for it right now and lock them in, would you really start out investing it primarily in equities and invest it more heavily in bonds as you age? You wouldn't, would you? The reason why you might invest more heavily in equities when young is because you're hoping to grow that money until you reach your desired wealth level and then start reining it back in when the wealth has accumulated. But if you hit that desired wealth level early, who cares what age you are?

Age matters a lot. It tells you how many earning years you have left and how much longer you have left to live, as you point out. When determining my own asset allocation, my age is a major factor in my decision. But I would design very different asset allocations for other people who are the same age, depending on their baseline risk tolerance (mine is very high, much higher than most people's), already existent wealth level, income, desired lifestyle, desired age of retirement, etc.

The baby is doing fine. Thanks for asking. (She's pulling up and just starting to cruise now. The video was taken a month ago.)

FLG said...

She's terribly adorable.

On the subject of risk tolerance, mine's much higher than most people as well. How much of that do you think is because we understand finance? Well, I just pretend to understand, but you know what I mean.

Andrew Stevens said...

Probably quite a bit. In my youth, I gambled as a part-time job and made decent money at it (on average) compared to my full-time job, but gave it up because the swings in luck were just too large for my comfort. (Random chance is a great deal streakier than most people seem to intuitively believe.) Moreover, I have adopted a very risk averse career path with economic security an extremely high value (i.e. the ability to quit my job at any time) and I certainly don't have any dangerous hobbies like skydiving or rock climbing or juggling chainsaws or anything. What I'm saying is that in general I'm a fairly risk averse person. So if my risk tolerance is higher than most people's in investing, it's probably because other people are irrationally averse to short-term losses and this is probably due to ignorance. My wife always remarks on how irritated I will get if I waste $50 on something, but I'll take thousands of dollars in losses in the equities markets with complete calm. (I explain to her that I still have the same number of shares that I did yesterday, but she still seems to think that it should bother me.)

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