Economists have developed various models aimed at defining the "optimal" behavior of a rational individual who wishes to consume, save and invest to maximize his or her well-being over time.
If Keynesian theory hypothesizes that saving is mainly correlated to personal income, in the XNUMXs Franco Modigliani and Richard Brumberg developed the theory of the "life cycle" of the individual, which remains the main reference for current savings models. According to this theory, the choice of savings levels reflects an intertemporal decision (spread over several periods), for which rational individuals maximize their overall well-being over the course of their entire lives, to keep consumption as stable as possible over time. This intertemporal “equalization” of consumption levels (consumption smoothing) would occur because reductions in consumption below the normal reduce the well-being of the agents more than it is increased by increases of the same size above the standard level.
The life cycle theory remains the main reference for current savings models
According to the life cycle theory, young people, in the initial phases of working life with lower income, wish to support their consumption by asking for loans, which will then be paid off in the years of professional maturity, with higher incomes from which to draw savings to accumulate wealth, and not having to reduce consumption in retirement years when income is lower. The accumulation of wealth would follow a “hump” shape”, low at the beginning of working age and in old age with a peak in the intermediate periods.
Life cycle theory considers the financial assets as vehicles for transferring resources between different periods over the course of life. In reality, however, other factors intervene which often do not allow for an "intertemporal equalisation" of consumption: consumption tends to increase in middle age and reduce after retirement, for reasons which vary from the lower availability of credit for young cohorts to inadequate planning. The decline in consumption in old age could be due to what behavioral economists call “hyperbolic discounting” (propensity to choose immediate rewards over those available later in time, even if the immediate ones are lower) which generates insufficient savings after retirement. However, it is fundamental for young people plan a supplementary pension in time, in the face of progressively reducing public pensions.
Modern portfolio theory hypothesizes how to also optimize the allocation of savings over time: it is necessary to consider the evolution of consumption and saving preferences (utility function), and the stochastic nature of the value of financial assets. According to Harry Markowitz, rational investors they maximize the expected return of their portfolio, minimizing its fluctuations (the variance), in the hypothesis of "risk aversion" (preference for a certain gain over a potentially equal but uncertain one) and an increasing relationship between utility and wealth. The evolution of preferences, and the uncertain predictability of financial returns, induce periodic reevaluations of investment choices: for example, with age, risk aversion and the preference for the protection of invested capital tend to increase.
How to behave to optimize financial investments
But in practice how an optimizing investor should behave during the vit cycleto? According to prevailing wisdom, the optimal portion of the portfolio invested in risky assets (equity) should progressively reduce with age (glide path). Let's see why. Corollary of the life cycle theory is the definition of "total wealth” of an individual as the sum of financial wealth and “human capital”, understood as the discounted present value of future earnings/income flows. Simplifying, human capital can be compared to a bond, since future earnings are relatively stable over time. For younger investors, human capital represents the main component of wealth and work is the main source of liquidity, furthermore the flexibility in changing the job offer allows for greater exposure to financial risk: it is reasonable to hold a significant share of wealth financial into equity. As age progresses, the value of human capital tends to reduce as a share of total wealth as the duration of the flow of future salaries shortens, while the relative importance of financial portfolios on assets increases and with it the exposure to the risk of market: it is therefore optimal to allocate a greater proportion of assets towards the bond.
Similar considerations apply to products widely used in managed savings. An example is funds target date which maximize expected returns at a predefined date with different objectives, from the generation of a supplementary pension to the creation of capital for specific projects. These funds tend to accumulate gains in the first years by concentrating the allocation on equity sectors with higher risk-return and then gradually increase less risky assets as the date approaches target: the prevailing academic approach behind the glide the life cycle theory of savings and investments remains.
°°°°The author is Phd Strategist of Euromobiliare Advisory Sim
