LIFE CYCLE INVESTING IN PAKISTAN

More and more individuals are looking for alternative investments

By Nayantara Noorani
Apr
 21 - 27, 2003

Portfolio management is not something that the average Pakistani concerns himself with as most individuals merely deposit their savings in bank accounts and at best in government saving schemes. However, as interest rate term structure has fallen over the last eighteen months, more and more individuals are looking for alternative investments so as to maintain the rate of return on their portfolios.

An important part of portfolio management is determining the risk and return objectives of an investor. These two objectives change for the investor depending on his stage in what is called the investment life cycle. To begin with, it must be remembered that the investor must satisfy his pre-investment needs which means having enough cash reserves to face uncertainties. In general, these needs may be classified in terms of whether they are immediate or long term as well as on the basis of their seriousness. An individual seeks to minimize the threat from major uncertainties through insurance. Minor uncertainties may be provided through cash reserves.

These needs change priority over a person's lifetime as his investment horizon shortens and hence govern the transition from one stage in the investment life cycle to the next. The investment life cycle has the following phases:

•ACCUMULATION PHASE: This represent the investors early to middle working years when the investment horizon is long term and the investor has growing earnings capacity. Due to the longer investment horizon, in this phase the investor is more open to taking higher risk in the hope of above average rewards.

CONSOLIDATION PHASE: At the midpoint of the investor's working life he enters the consolidation phase where he is concerned with protecting the assets that he has already accumulated. This of course implies a reduction in the investor's risk tolerance. However, since the time horizon is still relatively long term the investor is open to moderate risk options.

•SPENDING PHASE: The third phase in the investment life cycle commences when the person retires. At this point his overlying motive is to protect his accumulated wealth and hence only low risk investment options seem feasible, which provide at least enough return to protect the accumulated assets against inflation.

•GIFTING PHASE: The gifting phase runs in parallel to the spending phase for an investor. At this period of time, the investor is concerned with planning his estate and tax minimization. This phase is so called because at this stage the investor is willing to gift some of his assets if that would enable minimizing his tax liability.

The question that we find pertinent is where do equity investments fit in, in the context of life cycle investing theory? Quite obviously given the high risk high return profile of equities investors in their accumulating phase and to an extent consolidation phase would ensure that they have a relatively larger proportion of equities in their portfolios. On the other hand, investors in the last two phases in the investment cycle would steer clear of equities, making exceptions perhaps for stable dividend yielding companies.

More specifically we consider whether the theory of life cycle investing bears relevance in Pakistan. To begin with in Pakistani culture, the concept of insurance of personal wealth has yet to catch on. Traditionally this may be linked to the joint family system. More recently the nuclear family concept has caught up, especially in the larger urban areas, however, family ties for the most part remain strong enough such that in the event of a misfortune for one, close relatives chip in (more or less) willingly. Given that birth rates remain high in Pakistan, it is unlikely that people will stop relying on family for support.

At the same time, most people feel safer with accumulating cash reserves, which in the urban areas take the shape of bank accounts and in the rural areas postal savings, if not simply stashed under the mattress. Add to that the fact the until recent high return offered on the risk free National Savings Schemes, it is not surprising that personal portfolio management is not a concept that has caught on even in the urban areas. Given the lack of latent demand the financial industry in Pakistan has so far yet to formulate a portfolio management product, which targets individuals. But in our opinion, demand may be created by financial institutions through educating potential investors as to the possibility of earning above average returns.

Moreover, we believe this demand is in the process of taking natural birth given that as the term structure has declined over the last two years there has been development of more and more investment opportunities, available in the form of new financial products such as money market funds, equity market funds, etc. Consequently, individuals have begun to realize that they have choices but do not have the technical know how and expertise to make the optimum choice.

Of course the domestic financial industry would then need to help individuals structure their financial plans on the basis of their age, financial status, future plans and needs. This is where the investment life cycle theory comes in. Given Pakistan's demographic structure we believe that it is likely that a large portion of the target market for personal portfolio management would lie in the accumulation or consolidation phase. Hence, by definition we believe that there is considerable potential demand for equity investment in Pakistan.

At the same time, life cycle theory tends to be a little different with regard to entrepreneurs, and other individuals with exposure to relatively risky capital. The strategy for them may be to start off with no exposure to equities initially and instead to build up a stock portfolio as they age and their other assets become less risky. In fact, in Pakistan such well to do entrepreneurs form the majority of the individuals who practice personal portfolio management. Hence, their presence in the stock market.

We believe, that over the next year or two financial institutions would find it an increasingly feasible option to target individuals and help manage individual portfolios. In our opinion, the beginnings have already been made as more and more people in the prime of their career are looking towards the stock market as a feasible investment option. As these individuals age they would be interested in obtaining professional advice so as to modify their portfolios according to their changing needs.