Lifecycle investing is a strategy of reducing exposure to riskier assets as an investment goal gets closer to being met.
The Organisation for Economic Co-operation and Development (OECD) highlights lifecycle investing in its Pensions at a Glance - and the technique can be used for other investing goals as well.
From new to old
Lifecycle investing, writes the OECD, is a process that involves moving from riskier assets (such as shares) to less risky assets (such as cash deposits and government bonds) as an investment goal gets closer to being met. It theoretically reduces the chance of taking a big loss when a goal is close to being met.
Two sides to every story
All investments involve some kind of financial risk but, hopefully, higher risk shoud eventually lead to higher returns.
The risk/return relationship is important as it guides investors towards the types of products to buy. People looking for a "guaranteed return" may buy individual bonds and hold them to maturity - but this could produce a low return. Investors looking for higher returns will tend to buy products such as emerging market equity funds or individual shares but will be exposed to a higher risk of losing money.
Lifecycle investors might hold a mix of assets and reduce exposure to those at the higher end of the risk scale the closer they come to meeting their investment goal.
Economist Chris Dillow blogged for eZonomics on how to divide investments between safe and risky assets writing that it is important to have a balance that suits an individual’s tastes and circumstances. Dillow cites a simple formula for weighing risk and return developed back in 1969 and goes on to discuss what he sees are four key questions that arise from it.
When the time is right
ING senior economist Ian Bright explains in the eZonomics video The lifecycle approach to investing that the duration of an investment – or the amount of time before the money is needed – is an important consideration. Bright says that, according to the lifecycle strategy, early in life it’s easier to take risks because there is more time to make up for potential losses. But as an investor gets older or the date of the investing goal draws near, shifting to safer options can be helpful because losses (which are more likely when investing in risky assets) can have greater implications.
He gives the examples of how the strategy can be used for a range of goals, including retirement and children’s university fees.
“This life cycle approach is helpful in retirement planning and can also be used for different saving plans,” says Bright. “The principle is simple – the closer you get to your investment goal, the less risk you should take.”