Published On: Mon, Jun 8th, 2015

The right age for active investing

You may be investing in active funds or buying stocks directly. But should you continue with active investing all through your life?

In this article, we discuss why active investing becomes difficult after a certain age. We then introduce a concept called the age for active investing — the time of your life when it is appropriate for you to pursue active investing.

Age-related issues

Investing is about trade-offs. Active funds (funds that have a mandate to beat their benchmark index) can give you higher returns than index funds (passive funds). The flip side is that active funds carry higher risk; the risk that the fund manager’s bet to generate higher-than-benchmark returns turns wrong, resulting in the fund underperforming the index. This risk is called active risk.

Your ability to assume active risk reduces with age. The uncertainty in equity returns can cause anxiety, when you begin to worry about the possibility of a negative outcome on your investment.

A negative outcome does not relate only to losing capital. Not earning the minimum acceptable return (the return you require to achieve your life goal) is also a negative outcome.

As you age, your ability to handle anxiety reduces. Part of this is due to financial security; you typically prefer stability in your later years. Then, there is the case of cognitive impairment; it refers to the biological process whereby your mental faculty slows as you age.

You would agree that active investing requires continual monitoring of investments. After all, it is all about outperforming the benchmark index. So, if a peer fund does better than the fund you hold, you may want to shift to the peer fund. Your ability to analyse and take a decision to switch among active funds can diminish with age. True, you can hire a financial advisor to do the investing for you. But you should trust your advisor. The issue is that your anxiety over your advisor’s decisions could increase with age!

But then, you have to necessarily invest in equity at all times in your investing life. One way to reduce anxiety as you age and yet invest in equity is to pursue passive investing because it exposes you only to market risk; active investing carries an additional risk.

Equity allocation

Usually, you increase your equity allocation from the start of your career till you reach age 45. Thereafter, you tend to reduce exposure to equity till the age of 55. The equity allocation you have at 55 will continue till you retire.

This path of equity allocation in your investment portfolio determines the age for active investing. The period from the start of your career till 45 is when you need to undertake active investing, since that is when the equity allocation in your portfolio increases and peaks. Generating returns higher than the market is more rewarding when your equity investment capital is large. It thus follows that you should consider passive investing when you are approaching retirement and during your retired life. When you are closer to retirement, your objective should be to protect your existing wealth and take minimal risks in your retirement portfolio. Similarly, your objective post-retirement should be to generate stable returns to sustain your living, not to generate higher-than-market returns.

That said, you can pursue active investing even in your retirement if you are willing to assume active risk. Importantly, your mental faculty should be strong! But provide first for your basic living expenses using stable-income products such as fixed deposits.

[“source-thehindubusinessline.com”]