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Written by Remy Briand and David Owyong
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Friday, 05 June 2009 00:00 |
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Page 4 of 8
II. Rethinking Strategic Asset Allocation
The issues of 2008 also highlighted the mismatch between the investment horizon, the level of risk investors can bear and the characteristics of their portfolio. The most problematic cases were seen in the defined contribution space, but this issue also affects mature pension plans.
A retiring worker who expects to exit the workforce in one year should take on much less risk in his investments than a young worker in his 20s who is looking at another 40 years of employment. Sounds obvious? Yet individuals retiring in 2009 who put their savings in a 2010 target-date fund would typically have seen the value of their savings shrink by 20–30 percent. For someone purchasing an annuity at retirement under these circumstances, it means a permanent loss of revenues in the same proportion.
Understanding Investment Horizon And Downside Risk
Asset allocation decisions have to be made in the context of the risk-return characteristics of various asset classes and the tolerable downside risk. The latter is linked to the length of the investment horizon. The key investment problem is determining the acceptable level of downside risk while at the same time maximizing long-term real returns, subject to protection against inflation or deflation.
The investment horizon is an important element of this problem because it is related to the appetite for downside risk. While the returns of an asset may be positive in the long run, in the short run the possibility of losses cannot be ruled out. Long-horizon investors have greater capacity to withstand short-term losses because they see beyond these short-run fluctuations to the long-term trend that will in time reassert itself. Figure 5 illustrates the various dimensions of the problem.
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