START YOUNG AND FINNISH RICH

Retirement is the most important investment objective for most individuals. This column has discussed setting up such portfolios within the core-satellite framework. A reader wanted to know as to when it is optimal to set-up a retirement portfolio.
This article explains the importance of setting up retirement portfolios as young professionals. It then discusses the process of constructing such a portfolio, with a mention about the savings indiscipline and the ways to overcome the problem.
Start young, finish rich?
A young professional is typically saddled with debt such as home loan and car loan. Postponing investments for the retirement portfolio till mid-career is, hence, natural. Yet, young professionals would do well to set up such a portfolio early. Consider the reasons.
One, the power of compounding. The number of years for an investment to double can be approximated by this rule: 72 divided by the return. Longer the investment horizon, more compelling is the power of compounding. Smaller investment outlay is enough to achieve the desired portfolio value at retirement if an investor starts young.
Two, the ability to make risky investments is higher during initial career than during mid-career. This is because the human capital (present value of future income) is higher at a young age. The actual asset allocation policy will depend on the risk appetite and the income stability of the investor and not necessarily on the age.
Third, longer investment horizon provides a cushion for the higher volatility in equity prices. That is, a 30 per cent drawdown on the equity portfolio exposes the investor to high shortfall risk when she begins her retirement investment at 40 than when she begins at 25. This is not to say that equity is less risky in the long run. It is just that a longer time horizon provides more time for the portfolio to recover any capital losses.
Retirement process
In his book “The Law and the Profits”, C. Northcote Parkinson mentions a law that is important for retirement portfolios. Termed his second law, it states thus: “Expenditure rises to meet income.” This shows that a disciplined approach to savings is required.
The first step then would be to set-up automatic transfers from the bank account to the desired investment. This forces the investor to manage household expenses within the money available after making such investments. The investment amount would be based on expected return and the desired portfolio value at retirement.
The second step would be to decide on an asset allocation policy. A retirement portfolio can contain stocks, bonds, real estate and alternatives such as commodity. Equity and bond exposure can be through mutual funds.
A preferred structure would a core-satellite portfolio. The equity core may contain a broad-market index fund and the equity satellite, active style and sector funds. The bond core may contain PPF, bank deposits and fixed maturity bond funds. Instead of bond satellite, the investor can consider exposure to commodity and specialized funds such as market-neutral funds.
The third step would be the asset location policy as part of the tax-aware investments. It would be optimal to consider bond core as tax-exempt investment and the balance as taxable investment based on the current tax structure.
The final step requires periodic rebalancing of portfolios. This is required to ensure that the portfolio does not drift too far from the strategic asset allocation policy due to large changes in equity and bond prices.
Conclusion
We broadly discussed the need for a retirement portfolio and the process of setting up such a portfolio. Investors would do well to discuss with their investment advisors before setting up a retirement portfolio. The reason is that the portfolio value at the horizon would significantly depend on the asset allocation policy, which is based on the investor's risk tolerance level and the downside volatility of asset classes.