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Rich-for-life investing principles
April 10, 2008
Investment goals and risk capacity as well as financial position change over time. These changes must be taken into consideration in building a rich-for-life investment portfolio. Life cycle investing theory looks at these life stages and proposes portfolios for achieving investment goals, within set risk parameters, for different stages of your life.
Typically, younger investors would take a higher risk posture to garner higher returns and build up their wealth (Point A). If losses occur, they have the time to recoup. On the other hand, older investors would stay on the lower end of the risk/return line, preferring to protect existing wealth (Point B). Their investment posture would obviously be tempered from losses incurred in earlier years.
Franco Modigliani first put forward the "Life Cycle Hypothesis of Income, Consumption and Saving." His treatise contended that people move through a progression of dissaving (spending more than they earn in their younger years) to a period of net saving (as wealth increases) to another period of dissaving as they retire and live off previously accumulated financial assets.
Life Cycle Phases and Characteristics
Risk/Return Relationship at Life Cycle Phases
According to Donald R. Nichols who wrote a fine book on the subject of life cycle investing, investors must take into account five key elements in constructing a life cycle portfolio
Stability of principal,
Aggressive income, and
Growth and lump sum investments.
Investors achieve principal stability by searching out investments that provide optimum protection against market loss and value fluctuations. While the investment will earn some return, the paramount consideration is to guard against loss of the principal amount.
Current income generating investments such as dividend from common and preferred stocks, bonds, certificates of deposit, and savings accounts take on more importance as investors progress through the life cycle phases.
Capital growth investments seek long-term capital appreciation to build the desired level of wealth with which to live through the retirement years, an important investment strategy in the early to mid-years of the life cycle.
Ideal growth oriented investments include common stocks, mutual funds and bonds as well as hard assets such as real estate and precious metals. Company-sponsored pensions, profit sharing, and savings plans also build wealth rapidly, sometimes with the company making a substantial proportion of the contributions. Individual contributions can also be made pre-tax, adding to the growth capabilities of the investment.
Aggressive income and growth investments combine higher potential returns with a higher degree of risk and are appropriate for those in the accumulation phase of the life cycle. Again, stocks, bonds and mutual funds join forces with more speculative investment alternatives such as precious metals, currencies, commodity futures, and options.
Lump sum investments provide continual growth and wealth accumulation within a specific time frame. Zero coupon investments and certificates of deposits represent popular lump sum investments. These can be utilized during any phase of the life cycle.
[Excerpt from 100 World Famous Stock Market Techniques by Richard J Maturi, a widely syndicated investment columnist in the U.S. and the author of several books.]
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