Investing for Legacies – Investor Column

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Many of you want to leave money to your children or grandchildren, which begs the question: how should this affect your investment strategy? The answer, I’m afraid, is: it depends.

Let’s start, however, with how it doesn’t affect it. If you are investing for your descendants, you should not invest more in growth stocks. What matters are the long-term total returns. And growth stocks don’t necessarily offer more. Over the past 30 years, the FTSE 350 low yield index has returned 1.9 percentage points per year less than the high yield index. Growth actions have therefore not been a means of improving the situation of your children (or of yourself).

Granted, they have outperformed over the past few years, but this is most likely due to the downward trend in bond yields, which may well have come to a halt.

In fact, if you regularly review and rebalance your portfolio, there’s no difference between long-term investors who want to leave a legacy and shorter-term investors. For both, your time horizon is in effect as long as the time until your next rebalance.

Whether you want to leave a legacy or not shouldn’t affect your stock selection. It depends on whether and in what respects the market is informationally inefficient and where (if at all) there are cheap stocks – which is a matter independent of your attitude towards legacies.

Instead, leaving a bequest should influence your spending and asset allocation decisions; both are part of the same problem.

Obviously, if you want to leave a legacy, you need to spend less than if, like me, you were happy to let your wealth dwindle in retirement. This is even more true if you wish to make lifetime gifts to your descendants in order to reduce inheritance tax.

Here, however, a crucial question arises: how strong is your legacy motive?

If you are determined to leave all of your current wealth, you not only need frugal spending habits, but also a prudent asset allocation strategy, because there is a significant chance that equities lose money in real terms, even over a long period: this chance is about five percent over 20 years based on historical volatilities, and more if we take into account the possibility that past risks are not necessarily a reliable guide to future risks.

Less strong bequest patterns give us a lot more flexibility though. Wanting to leave one but being relaxed about the amount means you’re actually sharing the risk: the pain of losses is shared between you and your children and grandchildren. And if you pool the risk, you can afford to take on more. This should encourage you to hold more shares.

There is, however, a complication here: how do we manage retirement risk? zoned? This zone corresponds to the years just before and just after our retirement. In these years, a major drop in stock prices is a bigger problem than it would be if it happened sooner or later. If you’re young, a crash isn’t a big deal because you have less money invested and you can save more or work longer to recoup your wealth. And if you’re very old, that’s no problem because – to put it bluntly – you don’t have enough time left to spend your money anyway. If, however, you are between these positions, stock market losses are unpleasant. You don’t have years of work income to recoup the losses, but you have enough years ahead of you to worry about the impact it will have on your spending and bequest plans.

In such a scenario, we cannot rely on market rebound. Yes, it would if it fell because investors are worried about risk not materializing. But it would not rebound if investors rightly feared slower long-term growth; this is why the All-share index is lower in real terms today than it was in 2000.

Our degree of exposure to this risk zone varies from person to person. If you retire with a large retirement pension, your spending plans are not so sensitive to stock market wealth. If, on the contrary, you benefit from a defined contribution pension, you are exposed.

There is, however, a solution to this.

As long as we are in the retirement risk zone, we should have a conservative asset allocation strategy with plenty of safe assets, especially cash. However, as we age and escape this zone, we can afford to be more adventurous. If you don’t want to leave a legacy and have enough to live on anyway, that doesn’t really matter. If, however, you want to leave an inheritance, then – if you have enough to live on – you can afford to focus more on increasing potential returns and thus hold more shares in order to leave even more to your descendants.

But this, as Geoff Kingston of Macquarie University points out, is the exact opposite the classic advice of reducing equity exposure as you get older.

In fact, this advice has always been wrong as a general principle: as Ravi Jagannathan and Narayana Kocherlakota pointed out in 1996, it was only true for a some investors. The combination of bequest patterns and the risk zone of retirement means it’s particularly bad for some people.

The point here is simple but important. While some financial advice is true for everyone (like beware of expensive actively managed funds and not trading much), other advice is not. The question of how your equity exposure should change over your lifetime depends on idiosyncratic facts such as your exposure to the retirement risk zone; your holdings of safe assets; or the strength of your bequest motive. We cannot generalize.

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