Question

Explain how an individual's age and income level should influence decisions about how much to invest and decisions about risk allocation among different types of investments.

Answer 1

An individual’s investment decisions and risk allocation decisions are influenced to a large extent by that individual’s age and income level. When an individual is young then he has the capacity to make higher proportion of investments and undertake higher levels of risk. This is because when a person is young then the person does not have too many financial responsibilities and as such a large proportion of earnings can be allocated towards savings and investments. Also a young person has a higher appetite for risk and so can invest more in equities. As a person grows then number of financial responsibilities increases and responsibilities like needing funds for buying a house/car, needing funds for children’s education and marriage, health costs etc. crops up. These new responsibilities cause that individual to save a lower portion of his earnings. It should be noted that the absolute amount might be higher but the relative amount of savings (i.e. as a proportion of earnings) usually falls.

Similarly income levels also influences decisions with regards to investments and risk allocations. Higher income levels lead to higher levels of savings as a person with higher income level is able to satisfy the important necessities. On the contrary a person with a lower level of income may not be able to save much as majority of earnings will be spend towards meeting basic necessities of life. This applies to decisions about risk allocation among different types of investments in the same rationale. With higher incomes a person’s tendency to take risks will increase. However when income levels are low a person would like to park his hard earned savings in conservative instruments that have low levels of risk associated with them.