Look for less volatile and tax-efficient investments.
There is no ideal asset in finance just as there is no universal solvent in chemistry. An ideal asset should have stable real returns under all economic conditions. It must also be easily traded (liquid) and converted into other assets (fungible).
No single asset offers positive real returns under all conditions. The less volatile, like debt, are also less liquid, and tend to under-perform inflation. Equity is liquid and beats inflation but the returns are volatile. Real estate beats inflation but it's illiquid and the returns are volatile.
When creating portfolios, investors mix and match assets to get closer to the ideal. Any portfolio can be thought of as a single synthetic asset. It should have less volatility than its parts, it should offer real returns under most economic conditions, and it should be fungible and tax efficient.
Portfolios need periodic review. They need rebalancing, as economic conditions change, and so do the needs of the investor. How often a portfolio should be reviewed and rebalanced is another of those questions to which there is no “right” answer.
Broadly, middle class portfolios tend to be very similar. The weights remain in roughly the same proportion over very long periods. Most middle class portfolios are heavily overweight in real estate – usually self-occupied residential units.
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The bulk of the remainder tends to be debt (including provident fund holdings) and precious metals, held as jewellry. A very small proportion is equity and that is often indirectly held via mutual funds and unit linked insurance plans (ULIPs).
Very little of this classic middle-class portfolio is liquid. Real estate isn't liquid. Neither is jewellry – it's difficult to convert into cash except at big discounts. There are lock-in periods on ULIPs. The returns from such portfolios are volatile and may be negative for significant time periods.
The biggest holding – real estate – is itself a volatile asset. While real estate does, in the long run, tend to match inflation, the boom-bust nature of the property market means long periods of under-performance. Jewellry hedges high inflation but it doesn’t earn normal returns. Debt under-performs inflation for long periods of every economic cycle. ULIPs are inefficient ways to hold equity due to large initial commissions.
Most middle-class folks struggle to maintain their living standards post-retirement because their liquid assets don’t match inflation. The real estate component, which does match inflation, can only be converted to yield more liquidity after much soul-searching
Converting real estate to cash often means major family upheavals. Reverse mortgages are opposed by those who stand to inherit. Real estate can also be rebalanced by trading down. However, when selling a valuable property and buying a cheaper one, the surplus cash is often re-invested in assets that don’t match inflation.
This is far from an ideal asset allocation pattern. Financial planning theory suggests younger people should be more focussed on equity and gradually convert equity into debt as they age. A very small portion – perhaps 5 per cent of all assets at most- should consist of jewellry.
But most middle class people have fixed incomes. They invest as early as possible in real estate, out of prudence and a desire to live under their own roof. When they buy property, they tend to take out a mortgage on the most expensive unit they can finance. This means the bulk of their savings over the next decade or 15 years is ploughed into real estate.
If instead, they opted for less expensive housing and parked a higher proportion of savings in equity, the eventual returns would be closer to optimal. Post-retirement, their portfolio would better support their lifestyles.
The possibility of “trading up” is also there. Buy a relatively cheap residential unit when young. Invest a larger proportion of savings in equity while servicing the mortgage. Then buy a larger unit, once the first mortgage is cleared.
Doing things this way means forethought and recognising a few persistent fallacies. One fallacy is the belief that real estate is “safe”. It isn't - real estate prices are volatile. Another is the belief that equity is “unsafe”. In the long run, a diversified equity portfolio is as “safe” as real estate and offers higher returns. A third mistaken belief is that debt is “safe”. Pure debt doesn’t beat inflation.
Any portfolio held over the long run must not only beat inflation. It has to be convertible to other assets as and when required. Understanding this might be key to your happiness as you move closer to the senior citizen demographic.