October 3, 2020

Should you buy stocks when young or old?

One of the key insights of finance theory is that people should invest their savings in a portfolio containing the market portfolio of risky assets (such as stocks and corporate bonds) and the risk-free asset (government bonds). Moreover, the share of the portfolio invested in risky assets should only depend on the investors' level of risk aversion. This recommendation implies that people should invest a constant share of their wealth in stocks throughout their entire life.

One could be tempted to conclude that people should invest a constant share of their savings in stocks throughout their life. But this conclusion is not guaranteed because wealth is not the same as savings. People's wealth is made of their current savings plus the labor income they will earn in the future throughout the rest of their life. Even if you have zero euros on your bank account, you are still rich of your future labor income.

The notion that future labor income is part of individuals' 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 low-risk asset. The young have a long stream of future wages to come, which represents a safe asset. They can therefore afford to invest their savings in risky assets.

Conversely, older people cannot count as much on a safe stream of future labor income because most of their career is behind them. They should therefore invest their accumulated savings more cautiously.

Merton's reasoning is the rationale behind the usual financial advisors' recommendation that the fraction of stocks in people's portfolios should decrease with age.

This recommendation relies on the assumption that labor income is 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 graduate Sylvain Catherine (alumnus of both the Grande Ecole and the PhD program, now professor at Wharton) studies how the fact that wages are risky and correlated with the stock market affects households' 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. If you are interested in these issues, you should look at Sylvain's research here.

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