The Great Life Cycle of Risk Aversion Fallacy

If there is a single bit of established personal finance wisdom that is most popularly accepted and most wrong, it is what I call the Life Cycle of Risk Aversion. I have to name it myself because it is so widely assumed to be so obviously true that hardly anybody even notices it.

The Life Cycle of Risk Aversion is the idea that as you get older you should take fewer risks in your investment portfolio. When young, you should invest aggressively in stocks and similar exciting things. As you age, you temper your investments gradually into bonds and the like, until in retirement you have an all-boring portfolio.

This unspoken assumption of retirement planning is so pervasive that right about now you are probably wondering if I am really crazy enough to challenge it. Before clicking away, imagine the following “thought experiment.”

Suppose you are 25 years old and your great-uncle leaves you a very strange bequest. You get a million dollars, but only to be used for your retirement in 40 years. The terms of the will say that you must hire a money manager and, although you can talk to him all you want now, once he gets the money no communications are allowed until you are 65, when you get full control over the money.

What instructions would you give the manager before he sets off on his 40 year mission? Would you, for example, tell him to invest aggressively at the start but taper down to conservative investments in the final decade? If that makes sense to you, consider that investment results are multiplicative. The returns from each of the forty years are equally important to the final value of the portfolio. (Annual returns of +10%, -5%, +22% and -3% will always result in a four year return of +23.7% no matter what order they came in.) So as far as you know, starting out risky and ending safe has exactly the same expected result as starting safe and ending risky.

If risky-start-safe-end doesn’t make sense as a plan for this blind investment plan, then why would it make sense as generic advice to those saving for retirement? Well, of course, it doesn’t.

To be clear, there are many reasonable circumstances in which a person might want to reduce risk as they got older. A 55 year-old who has done well in his investments and is on an easy glide path to retirement might not want to jeopardize that to possibly make more money than he really needs. Alternatively, the same guy who has done poorly might want to reduce his risk so as to hold on to what he has left and fund at least a modest lifestyle.

If those two examples of rational risk reduction in late middle age have you convinced that maybe I am wrong, consider that a desire to increase risk in both those situations could be equally rational. The richer 55 year-old could decide to swing for the fences, reasoning that either he can live large in his golden years or, at worst, even if he loses half his kitty he can still be pretty comfortable. The poor 55 year-old might reason that he has some serious catching up to do and he is willing to accept the risk of possibly having to live off Social Security.

The point is that how much risk you should take on has a little to do with how much money you have got, a lot to do with your level of risk aversion, and just about nothing to do with your age. And risk aversion, even though it can be described with fancy math, is ultimately simply a personal matter of psychology. There is no logical argument to make that the 55 year-old who wants to increase risk is wrong, and therefore no reason to advise 55 year-olds in general to reduce risk in their investments.

So why is this universally accepted wisdom? My theory is that it is because in the late 20th Century, when this idea took over, risk aversion was well correlated with age. Folks born in 1915, who came of age in the depression, were much less willing to invest in risky things than those born in 1945, who in turn were considerably more cautious than my cohorts born in 1965, who learned about investing in the ‘80s and ‘90s.

If present trends continue, I expect that my kids’ generation will be much more risk averse than mine. So in a decade or two personal finance blogs (and books, if they still exist) will drop the idea that you should reduce risk as you get older. Or, possibly, they will come up with a reason why you should take on risk in mid-life but not before or after, to accommodate the inclinations of the various generations in their readership.

categories Investing | | datetime January 22, 2009 2:31 pm

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