The Hidden Danger of Target Risk/Date Retirement portfolio Without Hedging Human Capital

Why Target Risk

The recent decade has witnessed an explosion in investment vehicles for retirement finance. By vehicles, I did not mean IRA or 401(k) plan but what one can do with their money in IRA or 401(k). If one does not make their own decision but to invest in professional solutions, what can they do?

Most of these vehicles are designed according to the blue print of risk targeting. It is industry wisdom that different risk return appetite of the investors can be satisfied by provide a cascade of risk levels, i.e. equity exposure.  But why is it a good idea to target risk, or more specific, to target equity exposure?

The straight forward answer is that equity level is easy to track, if not the only thing to track.  Yet it is not always good idea to do something only if it is possible to do.

How to Target Risk

The old school of Target Risk Fund (TRF) is a good place to start the investigation. The funds are generally divided into three styles, aggressive, balanced or conservative.  Aggressive style targets high equity exposure, which floats around 80% of the total portfolio value. Conservative style targets low equity exposure, which usually is about 20% of the total portfolio value. Balanced style stands somewhere in between and breeds to sub style such as moderate aggressive or moderate conservative.  

The textbook usage of these funds has no bearing with retirement finance directly. People choose more aggressive equity style if they have a large risk. In contrast, people pick conservative equity style if they are fainthearted.

 However, a case could be made that individual at different phase of their retirement planning fit into these two categories neatly. When individuals are young, they have ample income other than that from their savings, so they could withstand market volatility. Such strong ability to resist volatility puts them at a vantage point to harvest the risk premium in the long run. In contrast, when individuals go into their twilights, they have to live off the income stream of their savings. They are scared of market turmoil and rightly so. So ideally, people at their youth will invest in aggressive funds while phase into conservative portfolio as they age.

Such is the corner stone of risk targeting. Notice the argument has no bearing with risk return tradeoff, at least directly. The logic is not that young people have higher risk exposure because they want higher return. Quite the contrary, they are rewarded with higher return because they are able to withstand greater risk. This difference appear to be nuanced but will prove to be a crucial  problem for standardized risk targeting, which will kick in the next paragraph.

The nice fairy tale is not happening in real world. Even if we take the assumption about people’s age risk aversion profile as granted, it is just an outrageous assumption, behaviorally, to require people to consistently shift their portfolios, let alone acquire the knowledge needed to calibrate such shift. However, industry has already solved this problem by providing an innovating instrument called Target Date Fund (TDF). The idea is simple and elegant. Professional manager can do the portfolio diversification and re-balancing for the clients.  Once a redemption/liquidation date is set (hence the name target date), manager will diversify the fund into a high equity level portfolio when it is far from redemption and switch it gradually to a fund that weighs heavily on bond side. All participants need to do is just to cash in at a consistent pace.

What is Wrong with Such Risk Targeting?

How can such scheme go wrong, since it has a good theoretical foundation and a good practical solution?  One may ask.

The caveat is that standardization kills the optimization. Once the investment concentrates a portfolio, it is impossible for the fund manager to cater people’s demand individually because managers can only optimize for the “average Joe” yet “average Joe” is neither you nor me.

For conveniences, let’s assume individual do maximize their utility by hitting constant risk level with their asset portfolio. Does that imply the savings account, or rather, the entire investment portfolio should hit that level?

The answer is obviously no. For starters, home equity is left out. But the elephant in the room is human capital, which is bulk part of the “asset” one has when they are young. The crucial problem here is that human capital is quite mercury  in its risk character.

Let’s give our “average Joe ” a PhD degree in computer engineering from MIT. He can choose to be a professor and thus earn a decent tenure wage, close to be risk free. He can choose to be a high frequency trader on wall street, which promise a fat bonus tied to financial market. Alternatively, he can kick off a tech startup, which could either be next google if it works out and bust if not. It is a gamble, but one that is not entirely correlated with financial market. Intuitively, these three career path will lead to three different retirement saving plan, under the constant risk aversion assumption.

For the professor “Joe”,  the TDF is a good deal. His human capital basically resembles a bond and he owned a lot of them. Therefore, he should be 100% in equity. Further more, consider the job security of tenure professorship, he has the potential to deal with a lot of equity risk, thus he could even consider leverage up when he is young.

For the trader “Joe”, however, the TDF does not make sense. His earning is already very risky and there is no reason for him for pile on more risk with his retirement money. It is bad to lose you job in a market crash. It will be worse that you lose your retirement saving along the way. Consequently, his risk bearing capability is low on the retirement finance side. He should be 100% in bond.  

For the entrepreneur “Joe”, TDF is not so great. His income is partial determined by the cyclical economy [hard to thrive if economy enters recession]. So does his human capital. If his adventure paid off, he will be in a good position to take serious risk. Otherwise, he will be very worried about his financial situation.Thus his retirement package probably should be split between stocks and bonds, a mediocre contingency plan for every scenarios.

Conclusion

Such is the hidden hazard of blindly investing in TDF funds. Unless investor know how their human capital behaves and hedge correspondingly, TDF exposes them to excessive risk taking. Although it is in general a sound philosophy to target the risk for retirement planning, it requires considerable sophistication as how to target the risk in the right way.

What does an Aging Population Mean for the Financial Market in the Next Decade?

I. What does Aging Mean for the U.S. Equity Market?

Zheng Liu and Mark Spiegel (2011) at the San Francisco Fed wrote a letter arguing that aging population bodes ill for the stock market.

Their argue that the age structure of the population, measured by the M/O ratio of middle age(40-49) over old age(60-69), seems to explain the PE of the stock market quite well. They postulate this process is driven by the fact that middle age people are saving thus buying stocks, while old age folks are dis-saving thus selling stocks. Therefore, when M/O is high, demand exceeds supply; when M/O is low, supply overwhelms demand. By projecting the historical trend, they painted a very bleak picture for the stock market going forward.

Figure 1: M/O ratio(Red) and PE(Blue), Dash is the projection

In response, John Cochrane wrote a blog arguing that age structure may not be the only variable that can explain the PE movement. In fact, it could be as simple as the mean reversion of the on-going cash flow. For example, when market is expansive in terms of PE, people expect the cash flow will lower, which pushes down the PE going forward. 

Nevertheless, the "grumpy economist" does seem to agree that the expected real return on equity market is not likely to be 8%, and aging is not the only suspect.

Professor Cochrane did not stop there, however. He laid out another sharp observation:

The right statistics to look at is not PE but the equity premium. When people are young, they take more risk and thus have a stock dominated portfolio. When people grow old, they shift their portfolio to a bond dominated portfolio. Thus if  Liu&Spiegel is right, we should observe that the equity premium is trending with the age structure.

II. What does Aging Mean for the Chinese Financial Market?

What light does the two paper shed on the Chinese financial market?

According to Liu&Spiegel, if M/O ratio is the driver, China appears to have a couple more good years before the M/O ratio starts to heading south. But that is too optimistic because the life cycle consumption pattern is different in China from that in U.S. 

In U.S. it is reasonable to assume that inter-generational transfer is relatively unimportant, considering the well developed mortgage market and the cultural emphasis of culture independence. Thus the peak saving rate may occur around 45 when the student loan and the first home mortgage are about to be paid off and people start to save for their own retirement.

In very contrast, the life cycle consumption decision in China cannot ignore inter-generational transfer. Parents 

provide finance the children from college to marriage, which is likely to deplete the bulk of their savings. The second generation, starting with a very healthy balance sheet, will save right away. And they had better save enough, because they are about to shoulder the financial burden of financing the retirement of their parents and the expenditure of their children. Consequently, the peak saving rate in China is likely to be earlier than that in the States, possible around 30-35. 

If we are only concerned by the the gross demand for saving, I am afraid China may have already passed its peak of saving. Household balance sheet is likely to deteriorate very soon once my generation start to feel the pain of the a 2/1 supporting ratio.

Not all hope is lost for the equity market, though. Another major difference between U.S. and China is the strength of the bond market. While their U.S. counterpart can effortlessly phase their portfolio into a conservative allocation, the Chinese household do not enjoy such luxury. Thanks to the ill-developed bond market, the saving account becomes the only viable solution for less risky allocation. To make things worse, the real return on the saving account is negative for half a decade. Simple portfolio optimization tells us that to shoot for fixed expected return(which may not be the case), the Chinese household has to over-allocate on equity market, and subsequently take more risk. Thus Chinese stock will experience less shock than the U.S. counterparts because Chinese households are forced into holding more equity position than they would like.

The flip side of the argument above is that Chinese bond market is going to be  BIG  in the next decade .  

III. What does Aging Mean for the Global Financial Market?

Previously I am confining myself to ignore the global flow of funds.

There are a few good reasons why that may not be a bad idea. For one thing, home bias is a well known mis-allocation pattern. For another thing, quirky regulation makes household difficult to diversify their asset globally, especially for countries that have capital control.

If all frictions are off and households are doing optimization correctly in a global scale, what will aging means for the global financial market?

It is an incredible hard question if one thinks twice about it. I have to leave it here for future exploitation. However, if the world consists only China and U.S., I would guess that Chinese people will be very interested in holding U.S. bonds rather than U.S. equity, which is contrary to John Cochrane's postulation of 1 billion Chinese buying S&P 500.