Allocating Assets by Life Stage
When allocating assets, the age of the investor is a key factor — although not the only one. Certain asset combinations fit particular life stages. For most investors, the primary goal is financing a comfortable retirement and then preserving their retirement resources.
A model for every age
The principles behind age-related investing are to start early, commit as many funds as possible, accept a trade-off of more risk for growth during younger decades and segue toward capital preservation in later periods.
In your 20s and 30s, time is on your side. The more you can invest, the more you will benefit over future decades from the magic of compound interest. (Note that $10,000 invested at age 25 at a 5% return will generate a whopping $70,400 by age 65 through compounding.) A rule of thumb suggests about 80% in stocks and 15% to 20% in bonds and cash while always holding at least six months of emergency savings in cash or laddered maturity bonds.
By the time you are in your 40s, you are reaching your career midpoint, moving toward your peak earnings potential. It may be time to invest in real estate for a home. It makes sense to dial up bonds closer to about 30%, with equities comprising around 70%. It is also smart to invest in yourself by working on an advanced degree or building work skills.
In your 50s and 60s, you might continue to dial down on risk, possibly moving to a 50/50 stock/bond complement. Specific percentages depend on when and by how much you intend to eventually tap your nest egg. The ratio also reflects your individual risk comfort level.
Each investment age is tailored to how much progress you are making toward your retirement goal. As you prepare to retire, you may restructure the portfolio to deliver income streams by shifting to higher dividend-paying stocks or bond funds.
There is no single ideal allocation strategy. The optimal portfolio at any given time is only confirmed with hindsight. The first prerequisite of a valid allocation is that the portfolio holder can stick with it through market ups and downs, which hangs on their risk tolerance. Many investors overestimate their emotional staying power, at least until a sickening market decline, such as in 2008, when the S&P 500 cratered by 57%. Those who panicked and sold during that crash might have been better served by a more conservative allocation mix that could have kept them invested.
Those in or nearing retirement normally avoid taking unnecessary risks for the sake of extra marginal gains. They can reduce the equity portion of their holdings, regardless of their risk capacity or tolerance.
As they start withdrawing funds, however, they face sequence risk: When withdrawals are no longer being replenished, their portfolios may suffer more in bear than bull markets, since bear withdrawals represent proportionately more of their assets.
Gliding toward your target
You can use target date funds, aka lifecycle funds, to eliminate the guesswork. These vehicles do the homework, automatically shifting allocations toward more conservative holdings in line with an investor’s age. A glide path formula calculates the adjustments over time.
Or you could create your own glide, using the 100 rule. The formula states: 100 minus your age is your bond allocation, with the remainder earmarked for stocks. For example, if you are 35, you would hold a 65/35 stock/bond mix.
Overly conservative, long-lived investors risk running out of money. With rising life expectancies, the 100 rule has now moved up to 110 or 120. The Social Security Administration pegs the average 68-year-old woman’s life expectancy today at 86.6. If a 40-year-old follows the updated rule, they might invest 80% in stocks and 40% in bonds, as 120 minus 40 equals 80.
Your financial adviser can help you plan an asset allocation mix according to your age and risk tolerance.