Four phases of the life-cycle
After studying this text the learner should / should be able to:
1. Describe the phases of the life-cycle of the individual.
2. Elucidate the codes / rules that pertain to each phase of the life-cycle.
3. Discuss the other codes / rules which apply throughout or during part of your life-cycle.
In this text we present four main sections:
- Four phases of the life-cycle.
- The financial system.
- Investment instruments.
- Investment principles.
The following broad categories and subcategories of investments exist:
- Ultimate investment instruments:
- Financial investment instruments (issued by ultimate borrowers):
- Debt instruments.
- Share (aka stock and equity) instruments.
- Real investments:
- Property (also called real estate).
- Other real investments (art, rare coins, antique furniture, etc.).
- Indirect investment instruments (issued by financial intermediaries):
- Issued by banks: deposit instruments.
- Issued by quasi-financial intermediaries: debt instruments.
- Issued by investment vehicles: participation units/interests.
We will discuss them in some detail. As the majority of portfolios are made up of financial investments, we pay special attention to the financial system from which they spring. In the last main section, we discuss issues such as the objective of investments, the relationship between risk and return, and portfolio management. We also touch upon the investment theories and extract from them the tried and tested principles of investments, such as diversification, the valuation of assets, and so on.
The above is of little use if one does not have investments. Only a small percentage of people (some studies say 6-10%) reach their financial security goal (FSG), and are able to replace formal work with other activities. For this reason we present upfront a discussion on the life-cycle, i.e. the four phases of life and the "rules" of the four phases that should be followed in order to achieve your FSG at an appropriate age.
There is a body of literature labeled life-cycle theory of consumption. Its genesis was in the 1950s and its champions were Franco Modigliani and his student Richard Brumberg, as expounded in papers published in 1954 and 1980. In essence the theory postulates that individuals make intelligent choices on the volume of their spending at each phase of their lives, and this is constrained only by the financial resources available over their lifetime. They tailor their consumption to their needs over the phases, independently of their income, and in so doing build up and deplete a portfolio of assets during their lives enabling them to live the last part of their lives ("retirement") sans recurring income from labour. This simple theory leads to important predictions about the broader economy.
The reality is that few individuals are able to reach their financial FSG, and the majority are dependent in the last phase of their lives on sources of income unrelated to themselves (usually their children / friends / government social security). We define "reaching your FSG" as building a portfolio of assets during the labour (income-earning) phases to a size that will sustain the individual and his/her dependent/s during the non-labour phase ("retirement"). Some individuals wish to reach their FSG early at, say, 40 years of age, while others wish to pursue an occupation until they are no longer able to.
The above can be put another way: individuals have a life-long budget constraint and endeavour to spread income earned during the labour phases over their remaining lifetime. This means that part of consumption is deferred during the labour phases; and the degree of deferring affects when the FSG is attained. Financial assets represent the vehicles for transferring consumption to the future, and financial liabilities (loans) are the vehicles for transferring future consumption to the present.
Thus, there are many choice-variables over the life-cycle, and they include:
- Income from labour (how to maximize it; how to guard / insure against disability / death).
- Expenditure / consumption (how to minimize; shift part to the future).
- Saving and building a portfolio of assets (the above apply in terms of how quickly; how to mix risky and risk-free assets = asset allocation decisions in various phases; how to hedge against inflation and contingencies).
- Debt / loans (the extent to which one is able to fast-forward "consumption" - here meaning the purchase of an essential asset, a dwelling).
A well-known statistic (of a large life assurance company) is that less than 10% of individuals reach their FSG. The reasons for this poor state of affairs are many, and they relate to neglecting the obvious codes or rules of behavior [financially and otherwise (which affects the former)] which should be followed over the phases of their lives.
This text does not expound on the life-cycle theory; rather, it endeavours to postulate the codes or rules of behavior (financially and otherwise) to be adhered to over your life-cycle. This is followed, in subsequent texts, by various related subjects (such as risk and return and asset valuation) that form an introduction to investments. Investments are of course irrelevant if you do not follow the codes / rules, because you will not have a portfolio of assets. If you do, having an understanding of investments cannot be overemphasized, even if you outsource the management of your portfolio.
It will be evident that individuals require three forms of security:
- Personal security.
- Health security.
- Emotional security.
- Financial security.
The financial security goal (FSG) is at the forefront of people's minds (or should be), and can only be achieved by following the rule that income must always be greater than expenditure (I > E). Debt can be part of the equation but only to the extent that debt is undertaken for good reasons (such as the purchase of a home) and that debt servicing (i.e. interest payments) is incorporated into E such that the condition I > E prevails. It will be evident that savings (S) is the outcome of I > E, and therefore that I > E = +S, and that the achievement of one's FSG at an appropriate or desired age is a function of maximizing I and minimizing E.
Because of our physiological and psychological hard-wiring and our environment, there is a pattern to our lives: we are born (0 years), nurtured and educated by our parents, expelled from home at 20+ years of age, undertake a career in order to survive, choose a life partner, have children who need nurturing and education (who are then ejected from the nest when we are 40-45), get too old to work effectively at 60+ years of age), and then depart for Heaven (some believe) at 80+ years' of age. We therefore have four phases to our lives:
- 0-20 Newborn to adulthood.
- 20-40 Adulthood to maturity.
- 40-60 Maturity to seniority.
- 60-80+ Seniority to exodus.
These phases are approximate because each person has a different life-script. Each phase has distinct characteristics / needs / desires and which need to be recognized, accepted and managed - especially in respect of our financial life - if you are to reach your FSG at a desired age.
Figure 1 portrays the ideal financial scenario for achievement of your FSG. It is self-explanatory. Below we discuss the "rules" of each phase.
Figure 1: four phases of life