Many of you want to leave money for your children or grandchildren, which poses the question: how should this affect your investment strategy? The answer, I’m afraid, is: it depends.
Let’s start, though, with how it doesn’t affect it. If you are investing for your descendants you should not invest more in growth stocks. What matters is total long-term returns. And growth stocks do not necessarily offer more of these. In the last 30 years the FTSE 350 low yield index has returned 1.9 percentage points per year less than the high yield index. Growth stocks, then, have been no way to make your children (or yourself) better off.
Granted, they have outperformed in more recent years, but this is very likely because of the trend decline in bond yields which might well have now stopped.
In fact, if you are reviewing and rebalancing your portfolio regularly, there is no difference between long-term investors wanting to leave bequests and shorter-term ones. For both, your time horizon is in effect as long as the time to your next rebalancing.
Whether you want to leave a bequest or not should not affect your stock selection. That depends upon whether and in what respects the market is informationally inefficient and where (if anywhere) cheap stocks are – which is a question independent of your attitude to bequests.
Instead, leaving a bequest should influence your spending and asset allocation decisions; the two are parts of the same problem.
Most obviously, if you want to leave a bequest you must spend less than you would if, like me, you are happy to let your wealth dwindle in retirement. This is even more true if you want to make some lifetime gifts to your descendants in an attempt to reduce inheritance tax liabilities.
Here, though, lies a crucial question: just how strong is your bequest motive?
If you are determined to leave all your current wealth then you need not just frugal spending habits but also a conservative asset allocation strategy because there is a non-trivial chance that equities will lose money in real terms even over a long period: this chance is around five per cent over 20 years based on historic volatilities, and higher if we factor in the possibility that past risks aren’t necessarily a reliable guide to future ones.
Less strong bequest motives, however, give us much more flexibility. Wanting to leave one but being relaxed about how much means that you are in effect sharing risk: the pain of losses is split between you and your children and grandchildren. And if you are pooling risk you can afford to take more of it. Which should embolden you to hold more equities.
There is, however, a complication here: how do we handle the retirement risk zone? This zone is the years just before and just after our retirement. During these years a big fall in share prices is a bigger problem than it would be if it came earlier or later. If you’re young, a crash isn’t a big deal as you have less money invested and can save more or work longer to recoup your wealth. And if you’re very old it’s not such a problem because – to put it bluntly – you’ve not long enough left to spend your money anyway. If, however, you are in between these positions, stock market losses are nasty. You don’t have years of labour income with which to recoup losses, but you do have enough years in front of you to worry about the impact it will have on your spending and bequest plans.
In such a scenario, we cannot rely upon the market bouncing back. Yes, it would do so if it falls because investors worry about some risk that doesn’t materialize. But it wouldn’t bounce back if investors were to rightly fear slower long-term growth; this is why the All-share index is lower in real terms now than it was in 2000.
How exposed we are to this risk zone varies from person to person. If you are retiring on a big final salary pension, your spending plans aren’t so sensitive to stock market wealth. If instead you have a defined contribution pension, you are exposed.
There is, though, a solution to this.
While we are in the retirement risk zone we should have a cautious asset allocation strategy with lots of safe assets, not least of these being cash. As we get older, though, and escape this zone, we can afford to be more adventurous. If you don’t want to leave a bequest and have enough to live on anyway, this doesn’t matter much. If, however, you do want to leave a bequest, then – if you have enough to live on – you can afford to focus more upon increasing prospective returns and so hold more equities in order to leave your descendants even more.
But this, as Geoff Kingston at Macquarie University points out, is the exact opposite of the conventional advice which is to reduce equity exposure as you age.
In fact, that advice has always been wrong as a general principle: a pointed out back in 1996, it was only ever true of a few investors. The combination of bequest motives and the retirement risk zone mean it is especially wrong for some people.
The point here is simple but important. Whereas some financial advice is true for everyone (such as be wary of expensive actively managed funds and don’t trade much), other advice is not. The question of how your exposure to equities should change over your lifetime depends upon idiosyncratic facts such as your exposure to the retirement risk zone; your holdings of safe assets; or the strength of your bequest motive. We cannot generalise.
