The Hindu Business Line : Retirement portfolios: Is more equity exposure at the horizon good?

Increasing equity exposure when risk is higher and cutting equity exposure when shortfall risk is lower may be a good strategy. Such a strategy is in line with typical investor behaviour — taking risks when facing losses but being conservative in the world of gains.

B. Venkatesh

Retirement portfolios are constructed to help investors meet their post-retirement lifestyle needs. Such portfolios typically follow a glide-path: equity exposures fall as the goal nears.

While constructing such a portfolio, we had to recently consider the reverse - increasing equity exposure as the investor nears retirement! Is such a strategy optimal?

Normal glide-path

A retirement portfolio is typically aggressive during the early years and tilts towards conservatism near retirement. This process of having more risky assets in the early years and more risk-free assets near retirement is called the glide-path.

The concept of glide-path has intuitive appeal for two reasons.

One, young investors have high human capital (present value of future income streams) and can afford to take more risk during the early years than in the later years. And two, the long investment horizon provides equity more time to recover from sharp losses during the intermediate years.

Of course, the actual exposure to equity would be dependent on the quality of human capital, not on age.

Thus, a person who has more bond-like (stable) human capital can take a higher exposure to equity than another person of the same age who has equity-like (unstable) human capital. But would a contrarian glide-path strategy perform better?

Reverse glide-path

This refers to a strategy that has high initial exposure to risk-free assets and gradually increases exposure to risky assets as the investor nears retirement.

The argument for such a strategy is compelling. Research conducted in this area by two Australian professors show that end-value portfolio is higher in the case of reverse glide-path strategy.

The study suggests that there is a 90 per cent probability of being richer due to this contrarian strategy.

Consider this. The return generated in the early years is small as the initial portfolio value is small. Asset allocation policy, it is argued, is not so important during this phase.

The portfolio value would, however, increase over time because of the income generated by risk-free assets invested during the early years and the periodic contributions by the investor.

It, therefore, makes economic sense to increase exposure to higher returns-generating assets (equity) in the later years. But is this argument tenable?

Shortfall risk

It is true that the expected returns from equity are higher than that from bonds. But the associated risks may be higher. Investors do not construct portfolios based on probabilities of losses. They are more concerned about the magnitude of losses should an adverse event happen. A loss of Rs 5 lakh on a portfolio of Rs 50 lakh at retirement will hurt more than a loss of Rs 10,000 on a portfolio of Rs 1 lakh in the early years, even though both constitute a loss of 10 per cent. Translated into risk, this means that the shortfall risk is higher towards the horizon. This is the risk that the end-value portfolio will fall short of the investment objectives.

Now, a higher equity exposure could lead to higher shortfall risk. This is because end-value portfolio with equity tilt will be heavily dependent on the market prices at the horizon to achieve the investment objectives. That is why a reverse glide-path, though attractive, may not be optimal from a risk perspective.

Conclusion

An alternative strategy would be to adopt a contingent glide-path. This calls for increasing equity exposure when shortfall risk is higher and cutting equity exposure when shortfall risk is lower. Such a strategy is in line with typical investor behaviour — taking risks when facing losses but being conservative in the world of gains.

(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investor-learning solutions. He can be reached at enhancek@gmail.com)