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October 2, 2021 First published October 3, 2020 Should you buy stocks when you are young? One of the key insights of finance theory is that you should invest your savings in a portfolio containing the market portfolio of risky assets (such as stocks) and the risk-free asset (such as government bonds) and that the share of the portfolio invested in risky assets should only depend on your level of risk aversion. This implies that you should invest a constant share of your wealth in stocks throughout your life We may be tempted to jump to the conclusion that you should invest a constant share of your savings in stocks throughout your life. But this conclusion is not guaranteed. Savings is not the same as wealth Your wealth is not just your savings but also the income you will earn throughout the rest of your life. Even if you have zero euros on your bank account, you are still rich of your future income. The notion that future wages is part of one's wealth led 1997 Nobel laureate Robert Merton to recommend that people should invest more in stocks when they are young than when they are old. Merton's reasoning is that wages tend to be relatively stable compared to the volatility of stocks, so the stream of future wages can be seen as a safe asset. The young have a long stream of future wages to come, which represents a safe asset. They can therefore afford to invest their current savings in risky assets. Conversely, older people cannot count as much on a safe stream of future wages because most of their career is behind them. They should therefore invest their accumulated savings more cautiously. The typical financial advisors' recommendation that people should hold more stocks when young and reduce their your exposure to stocks as they get older is based on Merton's model. Risky wages overturn Merton's conclusion Merton's analysis relies on the assumption that wages are safe. However, this assumption does not quite hold true in reality. Wages are sticky in the short run but highly correlated with economic growth and stock prices in the long term. Wages grow fast in fast-growing economies and stagnate in stagnating economies. Recent research by HEC Paris graduate Sylvain Catherine (alumnus of both the Grande Ecole and the PhD program, now professor at Wharton) shows how the correlation between wages and the business cycle modifies the optimal portfolio allocation. Sylvain argues that because the young are exposed to labor market risk, they should invest more cautiously than the old, overturning Merton's conclusion and financial advisors' wisdom. Once we account for the fact that wages are risky, it leads us to conclude that the young should not be too heavily invested in stocks because they are already exposed to the uncertainty of their own career. A specific implication is that you should hold more stocks if you have a relatively safe job and less stocks if you are in a more risky occupation. If you are interested in these issues, you can look up Sylvain's research here. |