Lifecycle Asset Allocation : The Case For And Against

Lifecycle asset allocation is an approach to asset allocation. Here, progressive risk reduction is effected in portfolios as the goal comes closer to falling due. It involves reducing the allocation to volatile assets in a portfolio over the tenure of the goal. It is done gradually over the final 10-15 years of a goal. An indicative risk reduction schedule for the portfolio of a 10 year goal is laid out in the graphic below. The initial asset allocation of the portfolio is 60% equity and 40% debt.

The relevance of lifecycle asset allocation to today's investors and portfolios is constantly debated. There are logical arguments available both for and against lifecycle asset allocation. Today I will examine both sets of arguments objectively. I will then offer my own opinion on the relevance of lifecycle asset allocation to today's portfolios.

The Case For Lifecycle Asset Allocation

Lifecycle asset allocation makes sense from a common sense perspective. This is because more money is allocated to safer assets as the tenure reduces. This reduces the impact of an adverse sequence of returns during the final few years of a goal's tenure. It therefore results in greater psychological comfort for investors. This in turn increases the likelihood of investors sticking to their plans over the entire tenure of the goal.

The Case Against Lifecycle Asset Allocation

Almost all arguments against lifecycle asset allocation center around expected returns. Expected long term returns when adhering to lifecycle asset allocation are bound to be lower. This is natural given that exposure to volatile assets is reduced over time. There is data available to show that maintaining constant equity allocations throughout the tenure of a long term goal may lead to better outcomes. The prime example of such studies is an American study titled Beyond The Status Quo : A Critical Assessment Of Lifecycle Investment Advice.

The study considers a couple investing for retirement between the ages of 25 and 65. It considers monthly stock return data between 1890 and 2019. It opines that a portfolio comprising of 33% domestic stocks and 67% overseas stocks has better expected outcomes than a portfolio with a stock-bond combination. This is true both during the accumulation period and post retirement. The all equity portfolio has been shown to have less severe worst case outcomes and greater longevity.

The Not So Apparent Truth

At this point, it seems clear that lifecycle asset allocation is not worth adhering to. But a more discerning eye would reveal a different story. An all equity portfolio may offer a higher expected return. But most investors do not behave rationally with volatile assets. Therefore their actual return is likely to be lower than the expected return. Returns are enjoyed only in hindsight. The investor's experience precedes the returns they enjoy. A stock-bond portfolio would ensure a less volatile experience for investors.

Finally, studies that opine against lifecycle asset allocation have primarily been conducted abroad. They primarily rely on equity return data from developed countries. There is no robust research data available to suggest that an all equity portfolio would produce similar results in India. Therefore Indian investors may be better off adhering to lifecycle asset allocation for now. And I personally do not expect to see reasons for this to change anytime soon.