How demographics affects stock valuations
New research suggests that stock and bond valuations are driven by the age of the population – at least in the US.
For most of us, how we invest is linked to our age. People will tend to save little when young (they may often be net borrowers instead), will put aside more as they approach middle age and will draw down their investments to fund their expenses after they retire. And if each of us does this individually, you might expect our combined decisions to have some influence on markets.
A population full of middle-aged savers might push up the price of stocks, bonds and other assets because there will be more demand (savings) chasing a limited amount of supply (the number of shares and bonds available to buy). When the proportion of savers is lower, the demand will drop (because the young are not yet saving) and supply could even increase (because older investors are now selling assets).
Stocks, bonds and inflation
This is an elegant theory if you are interested in the long-term forces that drive markets. But that doesn’t mean that the effect is big enough to be significant, given that markets are driven by many factors. So there have been a few research papers over the past couple of decades gauging whether a measurable relationship exists, including a new one by Arie Gozluklu of Warwick Business School and Annaïg Morin of Copenhagen Business School (Stocks vs. Bond yields and demographic fluctuations, Journal of Banking and Finance, 2019).
They find that in the US, the ratio of middle-aged people (those aged 40-49) to younger ones (aged 20-29) seems to have a solid relationship with asset prices. When this M/Y ratio is higher, dividend yields and bond yields tend to be lower: stocks and bonds are more expensive. They also attempt to explain why stocks (where dividends should reflect inflation over time) and conventional bonds (where interest is nominal – you get the same whether inflation rises or falls) have tended to move together, by suggesting that inflation risks may also vary with the M/Y ratio: a younger population may mean greater inflation risks.
The US M/Y ratio remains high, which could help explain why markets are performing well by global standards despite extreme valuations (this is my inference, not a conclusion they draw).
Importantly, the paper also looks at how well this model fits the rest of the world and finds that the results vary greatly. Since the stockmarket plays a greater role in individual saving in some countries – such as the US – than others, this makes sense. In practice, that may limit the value of the M/Y ratio as a tool for identifying markets with the best prospective returns. But it reinforces the value of international diversification to ensure your portfolio is not too exposed to factors affecting a single country.
I wish I knew what asset allocation was but I'm too embarrassed to ask
Asset allocation is the process of dividing your portfolio between different asset classes, such as shares, bonds, property, cash and gold. Each of these asset classes should behave in different ways in different scenarios, and have different potential risks and returns. The aim of asset allocation is to blend these together in a way that produces a combined level of risk and return that best suits an investor’s needs.
To take some extreme examples, a young investor saving for retirement a long way in the future and prioritising maximum growth above everything else might have 100% in shares, while a retiree who only cares about achieving a steady income might have 100% in bonds. More commonly, somebody who wants to achieve a combination of income and growth while also protecting their wealth from bear markets would typically have a portfolio split between different assets classes in a more balanced way.
Asset allocation is often divided into strategic asset allocation and tactical asset allocation. Strategic asset allocation is essentially what we’ve already described – how you allocate your money for the long term to fit your investment goals. Over time, the amount in each investment may drift away from your strategic asset allocation because some asset classes have performed better than each other. So on regular basis – maybe once per year – you will rebalance your portfolio to take it back to your original strategic asset allocation.
Tactical asset allocation is any temporary changes that you make to a strategic asset allocation as a result of current market conditions. If shares sell off a long way and now look cheap, you might chose to reduce the amount of cash you hold and increase your investment in shares. Profiting from tactical asset allocation is harder than it sounds and doing it too much can easily lead to higher costs and lower returns.