Did you know that income from your employment often helps you to diversify your investment risk?
Much of the value in a young private business is the anticipated contribution of the principals of the business over the years ahead. The same applies to employees who allow for the value of their future earnings potential in making financial decisions (for example, in taking out a mortgage): prospective earnings reduce financial risk for any individual. This will have more value for someone who is young than for someone who is old, or for someone who is healthy than for someone whose future earnings are constrained by ill health.
Your Investment Strategy
It has been recognised for some time that investment strategy should take account of the flexibility provided by future earnings from employment. In effect, these future earnings can be thought of as a holding of a “wage-linked bond” whose risk characteristics will vary from person to person and should refl ect the riskiness of an individual’s earnings. These implicitly risky bond holdings can be taken into account in setting strategy.
For example, individuals at the start of their career may be confident that employment (with whichever employer) will provide a means of financing savings over the years ahead. As the years pass, the value of this future stream of earnings becomes less. This justifies a gradual “lifestyle” phasing of investment strategy for many individual investors, whatever their risk tolerance. So even cautious, risk-averse investors might have their financial investments dominated by risky assets when they are young and move to a more obviously “conservative” mix, for example of bonds and some stocks, as they grow older. This approach is warranted because of the financial cushion and flexibility that individuals gain from the prospect of future earnings, not because over a long period equity risk diminishes.
Traditional Lifestyle Investing
This traditional life-cycle investing strategy phase is not appropriate for all individuals. It should work comfortably for the pension savings of government employees, who will not have any natural equity market exposure from their employment. It probably would not be appropriate for entrepreneurs whose own business is best thought of as a private equity exposure. For this type of investor portfolio balance may require from the outset a significant allocation within accumulated savings to high-quality bonds.
Read more from the Guide to Investment Strategy.