Han Dieperink: How many shares do you actually need?
This column was originally written in Dutch. This is an English translation
Ask an asset manager how many shares should be in a portfolio and the answer is almost always the same: it depends on your age and your risk profile. But is that really true?
By Han Dieperink, writing in a personal capacity
The assumption that younger people should invest more in shares and older people more in bonds seems intuitively correct. However, this approach overlooks many personal factors.
James Choi, Professor of Finance at Yale, has developed a formula in collaboration with two PhD students that takes a broader view. The formula incorporates income, savings, risk tolerance and future earnings into the calculation of an optimal allocation between shares and bonds. In many cases, the result is more aggressive than conventional advice, and with good reason. Future pay packets behave like a bond, as fluctuations in earned income are barely correlated with stock market returns. This implicit bond component is so significant that an investment portfolio can safely consist entirely of shares.
The Dutch difference
Choi’s formula does not yet take into account the extensive pension provision that is the norm here. For most Dutch people, mandatory pension accrual through employers constitutes a huge bond-like component of their wealth on top of their future earned income. Added to this is the AOW, an index-linked basic state pension that behaves like an inflation-proof bond. Anyone who adds pension assets and AOW entitlements to human capital will conclude that the implicit bond component of the average Dutch person is considerably larger than that of an American. In that context, the freely investable portfolio can accommodate a higher proportion of shares than the rules of thumb suggest.
As a person gets older and has saved more, the picture changes. A couple in their fifties with a combined income of 150,000 euros and 400,000 euros in freely investable assets would, according to the formula, be advised to allocate nearly 90 per cent to equities. If that same couple had saved twice as much, the recommended allocation would fall to just over 50 per cent. The greater the accumulated capital relative to future income and pension entitlements, the more the investment risk affects overall life wealth.
The dual bond component
What further distinguishes the formula from rules of thumb is the role of risk tolerance. On a scale of one to ten, the difference between a three and a five can lead to a difference in allocation of more than twenty percentage points. This is relevant because standard guidelines treat all investors of the same age as if they would all sleep just as soundly following a stock market crash. Furthermore, the formula does not optimise for the maximum final net worth, but for the utility that a person derives from their spending over the course of a lifetime. Every extra euro yields less happiness than the previous one, and the formula takes this into account.
Nevertheless, it is remarkable how conservatively many Dutch people invest their discretionary capital, whilst at the same time holding a huge bond-like portfolio through their pension fund. The tendency to invest the freely investable portion defensively as well effectively leads to a doubling of the bond component. The Dutch pension system is a luxury enjoyed by few countries, but that luxury only translates into greater prosperity if investors align their discretionary portfolios accordingly. That does not mean that everyone should put their entire portfolio into shares tomorrow. It does, however, mean that the question of how many shares you need – for Dutch people with a good pension build-up – yields an uncomfortable answer: probably more than you think.