Life Cycle & Wealth Cycle

Introduction

Financial needs are not static; they change as we age. A strategy that works for a 25-year-old is disastrous for a 70-year-old. The Life Cycle Hypothesis suggests that investment decisions should align with the investor's current stage of life, income capability, and risk appetite.

The Three Phases of Wealth Cycle

1. Accumulation Phase (Age 20s to 40s)

• Profile: Early career, starting a family.
• Financial Features:
  • Low Net Worth (few assets).
  • High Human Capital (many years of earning potential left).
  • Expenses are rising (Home loan, Children).
• Investment Strategy: High Growth.
  • Focus on Equity Mutual Funds (SIPs).
  • Time determines risk capacity. Since retirement is decades away, they can withstand market volatility.
  • Priority: Wealth Creation.

2. Transition / Consolidation Phase (Age 45 to 55)

• Profile: Peak career, children higher education/marriage.
• Financial Features:
  • High Income (Peak earning years).
  • Liabilities (Loans) are reducing.
  • Retirement is looming closer (10-15 years).
• Investment Strategy: Balanced.
  • Shift slightly from Aggressive Equity to Balanced/Hybrid Funds.
  • Start preserving the capital accumulated.
  • Priority: Goal Funding & Capital Protection.

3. Distribution / Spending Phase (Post Retirement, 60+)

• Profile: Retired, no active salary income.
• Financial Features:
  • High Net Worth (accumulated corpus).
  • Zero Human Capital (earning stops).
  • Dependency on investment income for survival.
• Investment Strategy: Income & Safety.
  • Focus on Debt Funds (SWP) and Senior Citizen Schemes.
  • Small equity exposure (10-20%) to fight inflation.
  • Priority: Regular Income & Capital Preservation.

The "100 Minus Age" Rule

A popular heuristic for Asset Allocation: Equity Allocation % = 100 - Your Age

• Age 25: Equity = 100 - 25 = 75% (High Risk)
• Age 60: Equity = 100 - 60 = 40% (Moderate/Low Risk)

(Note: In modern times, with longer life expectancy, some experts suggest "110 Minus Age" or "120 Minus Age" to ensure corpus lasts longer.)

Diagram: Risk Appetite vs Age

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Exam Notes: Writing the Answer

Question: "Explain the Investment Life Cycle. How does asset allocation change across different stages?" (12 Marks)

Model Answer:

Concept: The Investment Life Cycle divides an individual's life into phases associated with changing financial needs and risk profiles.

Phases:

1. Accumulation Phase (Early Life):
   • High time horizon, high risk taking ability.
   • Strategy: Maximize equity exposure for wealth creation.
2. Consolidation Phase (Mid Life):
   • Major goals (Education, Marriage) approach. Risk capacity reduces.
   • Strategy: Balance between growth and stability.
3. Distribution Phase (Retirement):
   • No salary; reliance on corpus. Lowest risk capacity.
   • Strategy: Focus on fixed income (Debt/SWP) to protect capital.

Conclusion: Financial planning must be dynamic, adjusting the portfolio mix as the investor moves from one stage to the next.

Summary

• Young: Time is your friend. Take risk. Buy Equity.
• Mid-Life: Balance growth with safety.
• Retired: Protect the capital. Generate income.
• Human Capital: Young people have high "earning potential" which acts like a bond, allowing them to take equity risk.

Quiz Time! 🎯

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