Interview Giovanna Nicodano: Life-cycle Risk-Taking with Personal Disaster Risk

“Long term unemployment should be taken into account for investment portfolio composition”

The younger you are, the more risky your assets, is the generally accepted idea around pension investments. After all, young people can compensate risks with many years of work. But what if they can’t? Giovanna Nicodano (Collegio Carlo Alberto, Universita’ di Torino) et al. analyzed what it means when young people consider the possibility of becoming long-term unemployed or incapacitated for work in the future.

“Personal disaster is not very common, but financial consequences can be substantial. A more even distribution of risky and less risky assets becomes efficient over the entire life cycle. Policy makers should aim at stimulating investment in risky assets by young people by  improving social insurance of personal disasters.”

“There is received wisdom that you should invest more in risky assets when you are young, because you have many years of labor income to diversify these risks. As you get closer to the pension age, you should divest from these risky assets and move towards safer investments. So far, this consensus has been hard to challenge. However, we found through observations and empirical evidence from other literature, there is one thing missing from these life cycle studies: personal disaster risk. This risk of long-term unemployment due to disability or job loss could have major impact on the ways pension funds invest and on social security costs in the long run.”

Efficiency
“This is a question of efficiency”, Giovanna continues. “Because there is much uncertainty around personal disaster risk. We don’t know whether or not it will hit us, or when this might happen. For countries with weakl long-term unemployment insurance, such as the US, our research shows greater efficiency when you don’t overinvest in stocks. When choosing a default investment portfolio for someone who is 30 years old, 50% in stocks is a better idea than 90%.Although there is no cross-country research yet that links social welfare programs  to the  financial risks people take, countries that spend little at social insurance for disabilities might find a reduction in financial risks people take, especially when they are young. This occurs for all young people  even if personal disaster only hits a very small group.. In countries with stronger social welfare, such s the Netherlands, young people might be willing to invest more in equities provided that personal disaster outcomes are covered by insurance. “

Accurate
So how should you be adapting investment strategy as you age, giving the huge potential loss when disaster strikes? New, related research also points in the direction of a more personalized approach to pension investment strategies, Giovanna explains. “The correlation between stock returns and labor income shocks is a key parameter to guide investment strategies. With new data from the Dutch Central Bank we were able to develop a much more precise estimation method for this correlation. We measure not only differences over time, but also between people over time. With this model you could improve i portfolio composition based on more than just age. We can take characteristics such as industry, geography and more into account. Especially in combination with robo-advising you could fine-tune investment portfolio much more accurately.”

Want to know more?
Read the paper Life-Cycle Risk-Taking with Personal Disaster Risk by Fabio C. Bagliano, Carolina Fugazza and Giovanna Nicodano