Thursday, June 17, 2004

Investment Portfolio

Standard advice for private investors is that an ideal investment portfolio depends on the investment time horizon. The longer the time horizon, the greater the proportion of the investments that should be held in equities. As the investor gets closer to retirement, the balance should shift towards fixed income securities, such as bonds.

There are many problems with this advice, discussed by Philip Coggan in the Financial Times recently ("The Long View" Saturday June 12th 2004). He cites a recent paper by Professor Zvi Brodie of Boston University: Life Cycle Investing in Theory and Practice, which critiques the simple assumptions about the relationship between risk preferences and time horizon, on which the standard advice is based.

Coggan also mentions the following argument, which appears to support the standard advice. "Equities must deliver a higher return over the long term to reward risk takers. Were they not to do so, the system of capitalism would break down. Investors would have no reason to hold equities at all. "

This argument appears to be a form of POSIWID – it implies something about the purpose of capitalism. But it is the wrong way around. The purpose of capitalism is to attract investors. Investors are attracted by risk and volatility, and by the illusion of having some information or insight denied to others. Therefore the system is required to produce risk and volatility and illusion.

A pessimist (or Marxian) might also comment that the past success of capitalism provides no guarantee of its future success. Perhaps there are long term trends that will destroy capitalism from within. We must be careful to distinguish POSIWID from FPOSIWIUTD – "the former purpose of the system is what it used to do".

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