Making the most of the seven ages of investment

MoneyWeek magazine cover illustration: seeing off the taxman

Your financial needs change as you get older, so your investment strategy needs to evolve in response. Matthew Partridge explains the key principles for making and keeping wealth throughout your life.

Fifty may be the new 40, or even the new 30. However, while we all might prefer to downplay certain aspects of the ageing process, its impact on our investments is one thing we shouldn’t ignore. While there are steps that investors of any age should take, certain assets are more suited to older savers, while others deserve a bigger share of the portfolios of younger investors.

Here are the key factors to take into account when considering your asset allocation at different points in your life – and how you can make the best use of your Isa allowance at each stage.

How bumpy a ride can you handle?

We all know that, over the long run, shares outperform bonds (so far at least). According to the latest Credit Suisse Global Investment Returns Yearbook, British stocks have returned an average of 5.5% a year over the last 118 years (that’s after inflation is taken into account – so it’s a “real” return). By contrast, gilts (UK government bonds) have only returned 1.8% a year. In the US, the gap is even bigger – the average is 6.5% a year for stocks and only 2% for bonds.

Of course, the trade-off is that shares can be extremely volatile. There have been 25 bear markets in the US (that is, periods where stocks have fallen by at least 20% from top to bottom) since 1929. That’s not a problem if you can ride out the volatility, but to do so, you need both the time and the mental attitude. We’d suggest having as large a proportion of stocks relative to bonds in your portfolio as you can tolerate (that is, as long as it isn’t ruining your sleep) for your given time horizon.

How long do you have?

That point about time is key, because the good news for shareholders is that the odds of shares beating bonds grows the longer you hold your investments for (assuming that future returns are broadly similar to historic ones, which of course can’t be guaranteed). Federal Reserve economist Pu Shen found that, between 1926 and 2002, a US investor had a 30% chance of losing money after inflation if they only held their stocks for one year.

However, if they held on for 15 years the chances of a real-terms loss fell to around 5%. And while there was a brief period a few years ago where bonds would have beaten stocks over a 30-year investment horizon (showing that you can’t take anything for granted), stocks are now firmly back in the lead. In fact it is rare for bonds to beat stocks over even a decade, let alone more extended time periods.

Always have a back-up pot

Liquidity matters. Various studies have shown that the most illiquid assets (such as venture-capital trusts) can produce the best returns (assuming you buy at a reasonable valuation, which is easier said than done). That’s because, in theory at least, investors should require greater rewards in return for taking liquidity risk – the risk that you can’t sell in a hurry.

But at least some of your investment portfolio needs to be readily accessible in case of emergencies. Life happens. And the risk is that a broadly passive buy-and-hold strategy won’t work if you have to sell your assets in a hurry to meet the cost of emergency bills. So you should keep at least 5%-10% of your investment assets in liquid form (such as instant-access savings accounts or very short-term bonds). This is partly to help you to meet unexpected expenses, such as home repairs or the need to buy a car; but you also want to have enough “dry powder” to allow you to buy shares cheaply if there is a sudden downturn in the market.

Consider your income options

Closely related to liquidity is the need to generate an income from your investments, particularly for those, such as retirees, whose income from other sources is often minimal. In theory, you can just take your income in the form of capital gains, by selling a portion of your portfolio each year and living off the proceeds. However, relying on this strategy alone can be risky – for example, if you have to sell investments at a point when markets have declined early on in your retirement (because you have crystallised a loss that would otherwise have recovered, given time).

While the income from dividends is more volatile than from bonds, research by Robert Schiller of Yale University has shown that dividends are much more stable than stock-price gyrations would imply. As a result, it may make sense to consider blue-chip stocks with a consistent record of paying out dividends as part of your income strategy (although you should pay attention to the tax implications, as it can be more advantageous to take capital gains rather than dividend income depending on your situation).

Cut your costs by investing tax-efficiently

Costs are the one thing you can control – you can’t predict your return, but you can ensure that you spend as little as possible in the process of getting it. That means you should take advantage of all the tax breaks that are on offer to encourage you to save for your own old age. Isas are the obvious choice (read on for more about those). Pensions are also worth considering, but bear in mind that the government has consistently cut the lifetime tax-free allowance (now just over £1m) and that governments generally see pension pots as more tempting, immobile targets than Isas.

Don’t put all of your eggs in one basket

Just as owning a number of individual stocks reduces your levels of risk without unduly diminishing your returns, owning a range of different asset classes that respond in different ways to different economic backdrops does the same. In terms of bonds, you might want to split your portfolio between gilts, index-linked bonds and high-quality corporate bonds (which traditionally have a low risk of default). We also suggest holding some gold as portfolio insurance – it tends to do well when other assets are doing badly.

Tactical asset allocation or rebalancing?

Tactical asset allocation (another City buzzphrase) is the idea of “tilting” your portfolio towards assets that you expect to do well in the short run. So if you think stocks are broadly overvalued, and set to fall, it might seem to make sense to sell and buy bonds or go to cash instead.

However, we’re not so sure. It rather goes against the spirit of having a long-term, low-maintenance investment strategy, and it also means increased transaction costs. You have to get your timing right too, which is notoriously hard to do. Even if you predict a peak successfully – selling your shares in 2007, say – you also have to get back in near the bottom, or else you risk earning a lower return than you would have achieved using simple buy-and-hold.

A better bet is to figure out your asset allocation (the proportion of your portfolio that you want to allocate to each asset) and then rebalance back to the original allocation on an annual or semi-annual basis. That way you will sell if an asset becomes very overvalued compared to the rest of your portfolio; or buy when an asset grows cheap.

How to steer your portfolio as you age

Below we take a simplified look at how you might want to split your assets between stocks and less risky assets (such as bonds) at various different life stages, assuming a relatively “hands-off” approach to investing. The percentage split in each case refers only to stocks and bonds, and assumes that you already have an allocation to cash.

Stage 1: Infants (median age 0-3 years)

Young toddlers can’t invest for themselves obviously, but you (or generous grandparents) can do so on their behalf. A junior Isa (Jisa) is available to those under 18 and living in the UK. This allows you to invest up to £4,128 per tax year. Like an ordinary Isa, you can invest in any combination of cash and investments, with interest and capital gains free of tax. The child will take control of the Isa at age 16, but they can’t withdraw any money until 18.

If the main focus is on saving for early adulthood costs – student life, a first car – your time horizon could be up to 18 years, which suggests that those with very young children could invest as aggressively as someone in their late 40s or early 50s. That indicates a portfolio split roughly 60% shares and 40% bonds, with the proportion allocated to shares reduced as the date at which the money will be used approaches (although you could be more aggressive, depending on your circumstances, as we’ll see).

A couple of points about saving for young children: firstly, your child has full control of a Jisa when they turn 18. If you have specific plans for that money (tuition fees say), then keep control of it by saving it in your own Isa. Secondly, only save for children if you aren’t jeopardising your own retirement. There is no point on filling a Jisa each year if you end up penniless and dependent on your kids in your old age as a result.

Stage 2: Teenagers (12-15 years)

At this stage, university may be on the cards, so your child’s portfolio should be more conservatively invested, as the money will be needed very soon. Still, even at this stage it may be useful to keep some in stocks. Your financial goals will be clearer – perhaps the money isn’t needed for university right now, in which case it could be rolled into an adult Isa, invested more aggressively, and perhaps kept to build a deposit for a property.

Stage 3: Graduates (24-26 years)

The investment needs of those in their mid-20s are a little more complicated. Some may be thinking about settling down (the median age of marriage in the UK and US is around 30), while most will have entered the workforce. This points to two major investment goals: saving for retirement, while building up enough money to buy a property in the shorter-term.

The lifetime Isa (Lisa) is designed to meet both of these goals. If you’re under 40, you can allocate up to £4,000 of your £20,000 Isa limit to one, and the government will add a 25% bonus. The money can be used to buy your first property, but withdrawals for any other purpose will be penalised until you turn 60. That makes it worth considering for retirement, particularly if you struggle to keep your hands off your savings. Any money earmarked for a property deposit should be invested cautiously, given that your time horizon is likely to be short-term (less than five years).

However, money you save for retirement at this age should be invested almost entirely in shares, to take advantage of your lengthy investment horizon. I’d suggest an 80/20 split between shares and bonds for your retirement fund and the opposite for any money allocated for a deposit on a house or flat.

Stage 4: Climbing the corporate ladder (36-38 years)

By their late 30s, most people will be climbing the career ladder and will have children and a mortgage. The focus should now be on retirement, perhaps 30 years away. If your employer matches contributions to a company pension, take advantage of this. We’d then suggest you save as much as possible into your Isa before turning to a self-invested personal pension (Sipp) – although pensions still offer very attractive tax benefits, the flexibility of an Isa is a major plus-point.

At this age, you still have around three decades to go before retirement (and maybe longer, assuming life expectancy continues to grow), so we’d suggest that your portfolio remain heavily tilted towards shares, because of their superior growth potential. Do remember to keep your emergency fund of cash topped up though, as your life risks (redundancy, say) and essential costs (mortgage, home maintenance, child-related bills) are particularly high at this stage. Life insurance, if you have dependents, is also a must.

Stage 5: Peak career (48-50 years)

By this stage, you may already be at or near peak earning power. With retirement still two decades away, you should continue to focus on shares, as there is still enough time to recover from an unexpected market downturn. However, consider a slightly more cautious investment position because the time you have left to retirement is diminishing (and if you’re lucky enough to be considering early retirement, you need to be more cautious still).

This suggests you should have around 60% of your investment portfolio invested in shares and 40% in bonds. If you do have spare cash to save, then this may also be the point where you want to top up savings for your children.

Stage 6: Approaching retirement (60-62 years)

At this stage you are getting much closer to retirement, so you should be thinking in more detail about how much you will need to fund your lifestyle, and the best way to go about that. Today the state pension age is 65 in the UK. However, this is set to rise to 68 by 2028, and seems likely to rise further in the future. As a result, while your investment timeframe will be much shorter than someone in their early 50s, you may still have around a decade before you finally retire.

The pensions freedom rules also mean that you no longer face an arbitrary cut-off date at which you have to buy an annuity. So you shouldn’t overlook the superior returns shares can offer – you could consider having around 40% of your portfolio in shares, or even split your investments equally between bonds and shares.

Stage 7: Retirement and second childhood (72-74 years)

By your early 70s you are likely to have retired fully, or drastically reduced your working hours. This means most of your income will be generated by your investments plus the state pension (assuming it still exists). It therefore may make sense – depending on any other sources of income – to use at least some of your retirement pot to buy an annuity (do shop around if you do so). This at least gives you a guaranteed “base-line” income to live on.

However, even at this stage, you may not want to abandon shares completely. Blue-chip companies with strong balance sheets and a strong record of paying dividends could potentially provide a decent income and some capital growth, as long as you are sufficiently diversified.

If the value of your estate adds up to more than £1m (assuming a couple, with a property worth at least £350,000), then you also need to consider your legacy and inheritance tax (IHT). Certain investments – such as specific Aim shares (but not all of them) – are free of IHT, but they can be risky, so make sure that this is not money you need. Other IHT management tips include giving gifts – gifts to a certain amount are free of IHT while others fall out of your estate once you have lived for a further seven years. If your estate is more complicated, then do take professional advice, as there are many other mitigation measures.