The following article, exploring issues of longevity and asset allocation, is by Lloyds TSB Private Banking. It challenges the notion that individuals must shun more risk as they age.

Editor’s note: The following article, exploring issues of longevity and asset allocation, is by Ian Martin, chief investment officer at Lloyds TSB Private Banking. As ever, the views expressed here are not necessarily shared by this publication. We do invite readers to respond.

I recently met a prospective new client in his mid-80s who is an active, inquisitive, knowledgeable and youthful investor.

He is wealthy, with a highly successful portfolio of businesses now run by the next generation who have already produced their successors.

Equities make up well over 80 per cent of his portfolio and are mainly growth or long-term orientated. The temptation when meeting someone of this age is to assume that their investment horizon must be shorter than someone in their 40s.

Many in the financial services industry, looking for simplicity, suggest that our holdings of equities should equal 100 minus our age. Hence a person of 40 years of age will hold 60 per cent and one of 85 will hold only 15 per cent in stocks.

However, this man’s investment ambitions are effectively unlimited. His family and descendants will continue for many years, necessitating a long-term strategic investment outlook that for most of his capital stretched way beyond this simplistic approach. Conversely, his own immediate needs were more consumption sensitive and necessitated a shorter-term outlook for a small proportion of capital.

Horizons

Families have long-term investment horizons not short-term ones, yet they often become dangerously short-term in their thinking, fundamentally compromising future generations and even at times current ones. Once we correctly identify our investment horizon we can use this to advantage and avoid the very high cost of short-term thinking.

Similarly, years ago I did an end-of-term speech at a school, where my focus was the future and what those leaving could expect.

This covered themes that have been core to my investment position for many years, including the speed of change, water scarcity, resource depletion, and technology, threats to mobility, liberty and democracy amongst others.

However the main focus was on people's longevity. They were expected to live well into their 80s and have much longer lives than their parents. The question was, would they be better lives?

Luckily, there was an expert on longevity present who challenged me on this, saying that rather than lasting until their 80s, most would make it into their 90s and some were already expected to live to at least 100. Furthermore some children being born today could expect to live to well past 110 years.

As unhelpful as this was, it confirmed the point on speed of change, whilst emphasising our potential understating of longevity. This has profound implications for us as investors and brings new risks but also great opportunities, necessitating action.

Life expectancy

Life expectancy has grown, as has the quality and cost of it. In Switzerland, a male retiring at 65 can be expected to need the use of his capital for at least another 20 years and his wife a little longer.

In the more prosperous parts of the US one member of a married couple retiring at 65 has a 25 per cent chance of living to 97 years of age.

For someone with limited capital this is not a short-term investment horizon, and the risks of getting it wrong are serious with time and often productivity working against easy recovery.

Furthermore, rather than costs falling as we age, they may actually go up as we pay to maintain quality as well as length of life. The risk associated with managing these unknown demands becomes more complex as time starts to work against us. Hence, we need to use time and compounding to our advantage for as long as possible.

Many of us need to be thinking much longer in terms of our investment outlook and potentially investing some capital more aggressively to take advantage of the fact that we are, by our biological nature, long-term investors.

Separately, those with serious surplus wealth need to recognise that the appropriate investment horizon stretches way beyond their own lives and they may need to respect the continuity in their family many generations ahead. This defines a long investment horizon for most of their capital and a shorter one for a smaller part if needed for immediate consumption. Similarities with an endowment style of investing are obvious.

In reality, few investors appreciate the risks of longevity in terms of capital or income requirements, while others may not recognise that they need to think and act much longer-term. Even fewer embrace the exciting investment options this brings.

Consider the following simple example:

Capital: $12,000,000;

Investment approach: Low-risk income-orientated

Investment returns post-tax: 3 per cent (around 6 per cent pre-tax and costs);

Inflation rate of lifestyle: 6 per cent (we use a low number; the reality is much higher. The uncertainty in this creates large risks);

Cost of lifestyle today: $300,000;

Capital expenditure: None (unrealistic) but constant standard of living expected.

This is a wealthy individual with a relatively low initial cost of living. Over time, the impact of an increasing cost of lifestyle means that more and more capital is spent to simply sustain a fixed standard of living and eventually capital runs out.

The investment profile of this investor is neither low risk nor income orientated. As capital is drawn, so the ability to service the cost of the individual’s lifestyle declines.

Therefore by investing in non-adaptive assets, with no growth and fixed return characteristics, considerable risks are taken.

Risk and purpose

Risk is a function of what the purpose of an investment is and not the nature of the individual asset or its volatility. In many instances what investors want and what they can have are very different. Failure to appreciate this can lead them to chase false objectives and fail to plan properly, so escalating failure.

Almost all clients I meet, regardless of age, wealth or circumstances need to have part of their assets growing and compounding, yet most have become shorter and shorter term in the way they invest. They fail to appreciate the risks and exploit the opportunity of their longevity.

This is partly due to fear but also shortcomings in some parts of the wealth management industry, which focuses on nominal capital preservation, as a technique to keep clients happy and disguise its own failures or lack of imagination. However, above all it is a failure of individuals to really understand why they are investing, for what purpose, how long for and to rejoice in the longevity they enjoy.

In reality, almost all short-term investment strategies are guaranteed to lose money in real terms. Large holdings of cash and fixed income assets all ensure wealth is not being preserved. Cash is a special concern because the liquidity and tactical options associated with it have costs in terms of capital preservation. It is unwise to pay this for too long unless one has a compelling future investment case. Many do pay these costs but never exploit the flexibility that cash provides.

Not a strategic asset

Cash is never a strategic asset and keeping large amounts of it for long periods of time is never an investment strategy. Such actions simply guarantee the destruction of wealth.

Holding too much cash or low-yielding assets can therefore be one of the most risky investment strategies, especially if you expect to live a long time and may actually need the cash at some stage.

Equally, inflation magnifies the liabilities we hedge via our investment activities and capital needs to grow to match these, otherwise additional sums need to be applied to the purpose. If these additional sums are unavailable we will fail.

Sadly, many investors do not see this and their actions ensure the destruction of wealth and the creation of long-term risks for them and their families. Longevity can quickly become an inconvenience as capital runs out long before it should.

Once we recognise that the investment horizon for us is not so short term we can address it. The first stage is to realistically gauge how long it should be and then determine what proportion of our capital can be invested long term and what short term. The idea we invest all our money in one way is clearly wrong.

The most attractive aspect of this (our longer lives aside) is that we can invest in exciting and profitable activities, thereby using increased risk appetite to our advantage.

Summary

As we live longer the possibility we outlive the usefulness of our capital becomes a big risk. This is especially relevant to those of us whose business or human capital is declining in value. As we draw on capital or it is lessened by inflation or taxation, this means its capacity to protect and sustain declines. Consequently it needs to grow much bigger long before we commence drawing it down.

Too many people keep all their money invested in short-term, low yielding, unadaptive assets and are setting themselves up for failure.

Hence, when people say they are interested in capital preservation and hold cash and bonds, I often have to remark they are deliberately focused on capital destruction.

They also imply a very pessimistic view on the future and their own place in it, so leaving good opportunities for others. For this I am grateful.