One of the most basic principles of investing is to gradually reduce your risk as you get older. That makes sense when you consider that retirees don’t have the luxury of waiting (or the capital, for that matter) for the market to bounce back after a dip. The dilemma is figuring out exactly how safe you should be relative to the stage of life you're in at any given point in time.
For years, a commonly cited rule of thumb has helped simplify asset allocation. According to this principle, individuals should hold a percentage of stocks equal to 100 minus their age. So, for a typical 60-year-old, 40% of the portfolio should be equities. The rest would comprise high-grade bonds, government debt, and other relatively safe assets.
Key Takeaways
- Reducing the amount of risk as you get older is one of the basic principles of investing.
- One of the common rules of asset allocation is to invest a percentage in stocks that is equal to 100 minus your age.
- People are living longer, which means there may be a need to change this rule, especially since many fixed-income investments offer lower yields.
- It may make sense to hold a percentage of stocks equal to 110 or 120 minus your age.
- You should consider other factors in your investment strategy, including the age at which you want to retire and the amount of money you think you'll need.
Reasons to Change the Rules
Pretty straightforward, right? Not necessarily. While an easy-to-remember guideline can help take some of the complexity out of retirement planning, it may be time to revisit this particular one. Over the past few decades, a lot has changed for the American investor.
For one thing, modern portfolio theory was birthed in the 1950's by Harry Markowtiz. Since then, life expectancy here (as in many developed countries) has steadily risen. The average American lives approximately 77 years, while the average lifespan at the theory's creation was closer to 70 years old. What's the lesson here? Not only do we have to increase our nest eggs, but we also have more time to grow our money and recover from a dip.
At the same time, U.S. Treasury bonds are paying a fraction of what they once did. As of May 2022, a 10-year T-bill yields 2.75% annually. In the early 1980s, investors could count on interest rates upwards of 10%.
Make sure you consult a financial professional when undertaking any investment strategy and before you make any investment decisions.
Revised Guidelines
For many investment pros, such realities mean that the old “100 minus your age” axiom puts investors in jeopardy of running low on funds during their later years. Some modified the rule to 110 minus your age. Those with a higher tolerance for risk may further modify that rule by going even further to 120 minus your age.
Not surprisingly, many fund companies follow these revised guidelines(or even more aggressive ones) when putting together their own target-date funds. For example, funds with a target date of 2035 are geared to investors who are currently around 50 (as of 2020). But instead of allocating 50% of their assets to equities:
- Vanguard's Target Retirement 2035 Fund has more than 70% allocated to equities
- T. Rowe Price's Retirement 2035 Fund builds in even more risk with more than 50% invested in equities
It’s important to keep in mind that guidelines like this are just a starting point for making your investment decisions. A variety of factors may shape an investment strategy, including the age at retirement and the assets needed to sustain one’s lifestyle.
Since women live nearly five years longer than men on average, they have higher costs in retirement than men and an incentive to be slightly more aggressive with their nest egg.
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Is There a Proper Asset Allocation by Age?
Your age dictates how much risk you're willing to take on in your investments. The general rule is that the younger you are, the more risk you're able to tolerate. The older you get, though, means you must cut back on the amount of risk in your portfolio. The common rule of asset allocation by age is that you should hold a percentage of stocks that is equal to 100 minus your age. So if you're 40, you should hold 60% of your portfolio in stocks.
Since life expectancy is growing, changing that rule to 110 minus your age or 120 minus your age may be more appropriate.
What Is the Old Rule About the Best Portfolio Balance by Age?
The old rule about the best portfolio balance by age is that you should hold the percentage of stocks in your portfolio that is equal to 100 minus your age. So a 30-year-old investor should hold 70% of their portfolio in stocks. This should change as the investor gets older.
But with individuals living longer, investors may be better suited in changing that rule to 110 minus your age or even 120 minus your age.
Does Changing Investment Portfolio Allocation by Age Make Sense?
It does make sense to change your portfolio allocation by age. That's because the older you get, the less risk you can tolerate. Put simply, you don't have the time to lose and replenish the capital base in your nest egg. Preservation of capital is important for those who are closer to retirement. As such, financial security is important to them since they can't wait for the market to bounce back.
The Bottom Line
Basing one's stock allocation on age can be a useful tool for retirement planning by encouraging investors to slowly reduce risk over time. However, at a time when adults are living longer and getting fewer rewards from “safe” investments, it might be time to adjust the 100 minus your age guideline and take more risk with retirement funds.
