Practice is far behind theory. Contemporary theory uses multiperiod hedging techniques and contingent claims analysis, while online quant models appear to be ad hoc blends of trial and error Monte Carlo forecasting and Markowitz static mean-variance model of efficient portfolio diversification.
Important insights from modern financial science:
- A person's welfare depends not only on their end of period wealth but also on the consumption of goods and leisure over their entire lifetime.
- Multiperiod hedging (rather than time diversification) is the way to manage market risk over time, ie. buckets.
- The value, riskiness and flexibility of a person's labor earnings are of first order importance in optimal portfolio selection at each stage of the life cycle.
- Habit formation can give rise to a demand for guarantees against a decline in investment income.
- Because of transaction costs, agency problems, and limited knowledge on the part of consumers, dynamic asset allocation will and should become an activity performed by financial intermediaries, rather than by retail customers (the value add of advisors).
- Measure of welfare: lifetime consumption of goods and leisure (vs wealth).
- Time frame: Many periods where stocks are risky in short and long term (vs single period where stocks seem safe in long run)
- Risk management: precautionary saving, diversification, hedging, insuring (vs precautionary saving, diversification)
- Quant model: dynamic programming and contingent claims analysis (vs mean variance efficiency and Monte Carlo simulation)
- Capital market expectations: inferred from current prices, eg. swaps curves and implied volatilities (vs based on historic statistics)
The fraction of an individual's financial wealth optimally invested in equity should "normally" decline with age for two reasons. The first stems from the fact that human capital is usually less risky than equity and that the value of human capital usually declines as a proportion of an individual's total wealth as one ages. Second, at any given age, the greater the flexibility an individual has to alter their labor supply, the greater the amount they will invest in risky assets. Those with more risky human capital should start out with lower levels of risky assets. The complexity of the financial services marketplace is a good reason for the industry to develop more simple, guaranteed return products and for advisors to help clients navigate the shoals.
Economists generally believe that people are made better off when offered more choices, as long as they can always choose what they had before (the value of choice and options). But when people do not have the knowledge to make choices that are in their own best interests, increasing the number of choices does not necessarily make them better off. In fact it may make them more vulnerable to opportunistic salespeople or unqualified professionals. The industry is heavily biased toward equities for the long run.
New Life Cycle Products
Accumulation phase: occupational funds, college accounts, real estate accounts
Retirement phase: escalating annuities, bundled-risk annuities
Escalating annuities provide guaranteed minimum standard of living defined in terms of a flow of lifetime consumption. Payments increase with inflation and with the performance of the market, and increases are locked in for life. (not the same thing as a variable annuity)
People don't like annuities because they lose control of their money.
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