A Life-Cycle Guide to Investing
Amal Al-Fawaz
10th April 2006
A life-Cycle Guide to Investing
“There are two time in a man's life
when he should not speculate:
When he can t afford it, and when
he can”.
MARK TWAIN,
FLLOWING THE EQUATOR
A life-Cycle Guide to Investing
(Cont.)
• INVESTMENT strategy must be keyed
to a Life Cycle.
• It is simple common sense to say that
a thirty-four-year old and a sixty-fouryear-old saving for retirement may
prudently
use
different
financial
instrument to accomplish their goals.
A life-Cycle Guide to Investing
(Cont.)
• The most important investment
decision you will probably ever make
the balancing of assets categories
{stock, bond, Real estate, money
market securities, etc.} at different
stages of your life.
A life-Cycle Guide to Investing
(Cont.)
• This chapter will show that:
 whatever your aversion to risk
 whatever your position on the eat-well,
sleep-well scale-your age, income from
employment, and specific responsibilities
in life;
 go a long way toward helping you
determine the mix of assets in your
portfolio.
Four Assets-Allocation
Principles
Before determining a rational basis
for making asset-allocation
decisions, certain principles must
be kept firmly in mind:
1. History shows that risk and
return are related.
Four Assets-Allocation
Principles (Cont.)
2. The risk of investing in common
stocks and bonds depends on the
length of time the investments
are held.
The longer an investors holding
period, the lower the risk.
Four Assets-Allocation
Principles (Cont.)
3. Dollar-cost averaging can be a
useful, though controversial
technique to reduce the risk of
stock and bond investment.
Four Assets-Allocation
Principles (Cont.)
4. You must differentiate between your
attitude toward and your capacity for
risk.
• The risks you can afford to take
depend on your total financial situation
including the types and sources of your
income exclusive of investment
income.
1. Risk and Reward Are
Related
• The higher risk is the price one pays
for more generous returns.
2. Your Actual Risk in Stock and Bond
Investing Depends on the Length of
Time You Hold Your Investment.
• Your stage in the life cycle is a critical
element in determining the allocation
of your assets.
• The length of your holding period is
important in determining your
capacity for risk.
2. Your Actual Risk in Stock and Bond
Investing Depends on the Length of
Time You Hold Your Investment. (Cont.)
• The age and the likelihood that you can stay
with your investment program not only
affect the risk you can assume but even
determine the amount of risk involved in any
specific investment program.
• The risk of investing in stocks also decreases
with the length of time they are held.
2. Your Actual Risk in Stock and Bond
Investing Depends on the Length of
Time You Hold Your Investment. (Cont.)
• You are reasonably sure of earning the
generous rates of return available from
common stocks only if you can hold
them for relatively long period of time,
such as twenty years or more.
• These returns are gained by the steady
strategy of buying and holding a
diversified portfolio.
2. Your Actual Risk in Stock and Bond
Investing Depends on the Length of
Time You Hold Your Investment. (Cont.)
• The most reason for investors to
become more conservative with age is
that they have fewer years of labor
income ahead of them.
• They cannot count on salary income to
sustain them should the stock market
have a period of negative returns.
3. Dollar-Cost Averaging Can Reduce
the Risks of Investing in Stocks and
Bonds (Cont.)
• This technique is controversial, but it
does help you avoid the risk of putting
all your money in the stock or bond
market at the wrong time.
• Dollar-cost averaging means investing
the same fixed amount of money over
a long period of time.
3. Dollar-Cost Averaging Can Reduce
the Risks of Investing in Stocks and
Bonds (Cont.)
• The average cost per share is actually
lower than the average of the share
prices during the period when the
investments are made.
3. Dollar-Cost Averaging Can Reduce
the Risks of Investing in Stocks and
Bonds (Cont.)
• A drawback to dollar-cost average is that
brokerage commissions are relatively high
on small purchases, even when you use a
discount broker. For that reason, it is usually
advisable to buy larger blocks of securities
over longer time intervals.
• The advantages of dollar-cost averaging are
to join the dividend-reinvestment programs
of those companies that have them.
4. Distinguishing between Your
Attitude toward and Your Capacity
for Risk
• Kinds of investments that are
appropriate for you depend
significantly on your sources of income
other than those derived from your
investment portfolio.
• You're earning ability outside your
investment, and thus your capacity for
risk, is usually related to your age.
Three Guidelines to Tailoring a
Life-Cycle Investment Plan
• There are general rules
• Serviceable for most individuals at
different stages of their lives
• No guide will fit every individual
Three Guidelines to Tailoring a
Life-Cycle Investment Plan
1. Specific Needs Require Dedicated
Specific Assets
2. Recognize Your Tolerance for Risk
3. Persistent Saving in Regular
Amounts, No Matter How Small,
Pay Off
1. Specific Needs Require
Dedicated Specific Assets
• Keep this rule in mind
• Building an Investment Strategy:






Case of young couple “20”
Retirement nest egg
Long-term objectives
Home down payment 30,000 or
College tuitions for years
In both cases money should be
invested
2. Recognize Your Tolerance for
Risk
• Successful financial planning
more of an art than a science
is
• Decide what proportion should be
deployed among different asset
categories
2. Recognize Your Tolerance for
Risk (Cont.)
• Risk tolerance is an essential aspect
of any financial plan
2. Recognize Your Tolerance for
Risk (Cont.)
Risk tolerance can evaluate person’s
attitude toward risk:
 Common stocks and long-term bonds
are less risky when invested for a
long time period
 Accepting considerable short-term
fluctuations in one’s portfolio would
make no harm
 September 11 is an example
2. Recognize Your Tolerance for
Risk (Cont.)
• Subjective considerations play a major
role in the asset allocations
• One’s
portfolio
depend
on
his/her
aversion to risk
• Simple
questionnaire
discovering
person’s
tolerance level
can
help
investment
in
risk
3. Persistent Saving in Regular
Amounts, No Matter How
Small, Pay Off
• What if one has no assets to allocate?
• Accumulating retirement savings often
seems out of reach
• Don’t despair
3. Persistent Saving in Regular
Amounts, No Matter How
Small, Pay Off
• A program of regular savings plan each
week can solve the problem
• In time it would produce substantial
sums of money
• If a new thousand dollars added to the
savings funds at the beginning, the
final sum will be increased significantly
3. Persistent Saving in Regular
Amounts, No Matter How Small,
Pay Off
How Retirement Funds Can Build:
What Happens to an investment of $100 a Month,
Earning an 8 Percent Return Compounded Monthly
Year
Cumulative
Investment
Annual
Income
Cumulative
Income
Total Value
1
2
$1,200
2,400
$53
157
$53
210
$1,253
2,610
3
4
5
3,600
4,800
6,000
270
392
524
480
872
1,396
4,080
5,672
7,396
12,000
24,000
36,000
1,368
4,501
11,422
6,414
35,284
113,594
18,414
59,284
149,594
10
20
30
3. Persistent Saving in Regular
Amounts, No Matter How
Small, Pay Off (Cont.)
• Pick
no-load
mutual
funds
to
accumulate your nest egg as direct
investment of prohibitively expensive
• Mutual
Funds
permit
automatic
reinvestment of interest, or dividends
and capital gains
3. Persistent Saving in Regular
Amounts, No Matter How
Small, Pay Off (Cont.)
• Check if your employer has a matched
savings plan, if it is available your nest
egg will grow much faster
The Life-Cycle Investment Guide
• Wealth should always be divided into
three parts:
1. Third in Land
2. Third in merchandise (business)
3. Third ready at hand (in liquid form)
Rabbi Isaac, Talmud
• Such an asset allocation is hardly
unreasonable
The Life-Cycle Investment Guide
(Cont.)
• In general, make the proportion of
bonds in one’s portfolio equals to
one’s age:
1. Mid-Twenties
2. Late Thirties to Early Forties
3. Mid-Fifties
4. Late Sixties and Beyond
The Life-Cycle Investment
Guide (Cont.)
Age: Mid-Twenties
Lifestyle: Fast,
aggressive.
Age: Mid-Twenties
10%
20%
With a steady stream
of earnings, capacity
for risk is fairly high.
Need discipline of
payroll savings to
build nest egg.
5%
CASH
BONDS
STOCKS
REAL ESTATE
65%
The Life-Cycle Investment Guide
(Cont.)
Age: Late Thirties to
Early Forties
Lifestyle: Midlife
crisis.
For childless career
couples,
capacity for risk is
still quite high.
Risk options
vanishing for those
with college tuitions
looming
Age: Late Thirties to Early Forties
10%
5%
CASH
30%
BONDS
STOCKS
REAL ESTATE
55%
The Life-Cycle Investment
Guide (Cont.)
Age: Mid-Fifties
Lifestyle: Many still
Age: Mid-Fifties
13%
reeling from college
tuitions. No matter
what the lifestyle,
this group must start
thinking about
44%
retirement and the
need for income
protection
5%
CASH
38%
BONDS
STOCKS
REAL ESTATE
The Life-Cycle Investment
Guide (Cont.)
Age: Late Sixties and
Beyond
Age: Late Sixties and Beyond
15%
Lifestyle: Enjoying
leisure activities
but also guarding
against major
health costs.
Little or no
capacity for risk.
10%
CASH
BONDS
25%
STOCKS
50%
REAL ESTATE