Academic journal article Journal of Economics and Economic Education Research

Asset Allocation Based on Accumulated Wealth and Future Contributions

Academic journal article Journal of Economics and Economic Education Research

Asset Allocation Based on Accumulated Wealth and Future Contributions

Article excerpt

INTRODUCTION

The typical asset allocation model almost exclusively focuses on the risk/return relationship for assets already realized and invested. There is the classic age in bonds or 100 minus age model to determine the percentage in equities. A variety of target date or life cycle funds follow this type of concept. Other models are based solely on an investor's risk aversion and will often delineate portfolios as conservative, moderate, or aggressive. Regardless of the asset allocation model used, two major considerations are invariably overlooked: current wealth and expected future contributions. Friend and Blume (1975) first pointed this out and even stated, "virtually all empirical applications of portfolio theory have ignored human wealth in spite of its obvious importance to the demand for risky assets." This issue remains in the financial planning area to this day.

To explain further, consider two types of investors with 15 years until retirement. Each earns $50,000 a year and both plan to make $10,000 contributions each year. However, the first investor has zero invested wealth while the second has already accumulated $300,000. A typical age rule might suggest a 50/50 mix. However, this is biased downward for both investors if future contributions are not considered.

Although the first investor has zero accumulated wealth, there is $150,000 in "riskless" future contributions. This is riskless only in the sense that it is assumed the investor will not lose his or her income stream, face unexpected expenses, etc. that would derail future planned contributions. Thus, for the first few years, this investor may want to consider 100% in equities until wealth at risk relative to future contributions has increased. Large losses at this point in the accumulation phase, despite the late start and limited time horizon, will be mitigated by future contributions. In addition, future social security payments which can also be considered a risk-free annuity will be a much larger proportion of retirement income, further increasing the actual percentage of wealth in relatively risk-free low yielding assets.

For the second investor, wealth at risk is much greater as future contributions are only 50% of accumulated value. However, the investor still has 33% in "riskless" future contributions, $150,000/$450,000. At this point, a true 50/50 mix would mean the investor should have $225,000 in equities. Depending on asset returns and how the suggested asset allocation adjusts through time, this investor's initial contributions will be directed towards both bonds and stocks although not at the implied 50/50 ratio.

Thus, financial planners and investors need to focus not just on the risk/return relationship for assets in the retirement account, but also need to account for those assets that have not yet been earned, but will be directed towards retirement. This study shows the risk/return characteristics of the classic investing approach versus considering the inclusion of future contributions. Findings suggest with little difference in terminal risk, expected terminal wealth could be increased by approximately 10% for investors with no accumulated balances. For those with significant balances, the consideration of future contributions is not as critical.

TARGET INVESTMENT GROUP

Although this analysis can be effectively applied to any investor at any age, it is likely more relevant to investors that have greater certainty about future contributions. This would seem to be particularly apt for investors in the 50 to 65 age group category as their children are likely out of college, income is peaking, retirement savings have become a priority, and on average, there is less uncertainty about job security. These factors should lead to greater certainty about what can and will be contributed towards retirement.

Unfortunately, many investors even at this age have little savings. …

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