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There used to be a mantra in personal investing that helped define your asset allocation. Essentially, you took 100 and subtracted your current age. The result was how much of your portfolio should be invested in stocks. The remainder would be invested in bonds.
However, times have changed. People are living longer and want to retire earlier. That means your portfolio needs to last much longer — it’s being stretched both ways. The old rules are being replaced.
It’s time for a new rule of thumb
If we applied the old heuristic, at my ripe young age of 24 I would have 76% of our portfolio in stocks. 24% of my portfolio would need to be in bonds. That seems absurdly conservative. Correct that, it is extremely conservative.
I’ve read in a few personal finance magazines that a new rule of thumb is being applied. Instead of subtracting your age from 100, you subtract from 120. A simple change, but a significant impact. It moves the bar up 20 percentage points.
With the new rule of thumb, I should have 96% of my portfolio in stocks. That seems more accurate. I’ve got at least thirty year to retirement. I can take the extra risk.
Why stocks are important
You might be thinking “So what’s the big deal if 16% of your portfolio is in bonds? I thought bonds were safe investments.”
It is true that bonds are generally safer than stocks… and due to this returns are going to be lower over the long term. Stocks carry a risk premium. As an individual investor, you need incentive to take risk. That incentive with stocks is — over the long run — higher returns. If you couldn’t earn higher returns in stocks then everyone would invest in safe assets like bonds, CDs, and saving accounts. There would be no incentive to take the additional risk.
Stocks provide portfolio growth in the long term. Since my investment horizon is so far out, I need to maximize my opportunities for growth. Stocks should trump other investments over the next 30 years.
A Word of caution
Any heuristic — or rule of thumb — should be used with a grain of salt. They all will have flaws in different situations. Whether it be the 120 minus your age formula or looking for stocks with a low P/E ratio, don’t just use the ideas without any deep thought on your part.
For me, the 120 rule seems to work. We’ll slowly adjust our portfolio to become more conservative over time. Our target retirement funds will make that pretty easy for us as well.
11 Comments, Comment or Ping
Livingalmostlarge
Personally I don’t think it’s the answer. I think that you should keep aggressive even in retirement because it could lost 30-40 years. And the risk is well worth it.
Aug 12th, 2008
Kevin
@LAL: I’m guessing you mean it could last 30-40 years?
I think it depends on your portfolio size and cost of living. Being heavy stocks at age 65 now is really hurting because your portfolio has tanked 10-15% in the past twelve months. Compare that to a balanced portfolio that would experience less loss in the meantime.
I think once you retire you are looking for consistent income to keep up your lifestyle.
Aug 12th, 2008
Livingalmostlarge
It depends. What percentage were you thinking? I would probably leave mine somewhere at 70% stocks/30% bonds. Currently we’re at 90% stocks and 10% cash. When we have more assets I’ll likely decrease it to 80%/20% because the extra growth isn’t worth the risk.
Also realizing that out of my 80% stocks there will be a huge chunk of very aggressive individual stock investing which my DH loves. So the beta is very risky so to mitigate it we’ll need to have more bonds/cash.
Aug 12th, 2008
Matt
As long as you’re in decent health and plan on working into your 60s, there is little worry of ignoring bonds all together until you are 40. The only caveat would be maintaining a stable emergency fund.
Even when you hit 40, I would suggest moving into the higher risk bonds unless your investments have done phenomenally well or you choose to take early retirement.
Therefore, my vote says the old “age & asset allocation” theory is purely academic and of little value.
Aug 12th, 2008
Kevin
@LAL: I don’t have a set percentage in my head. 70/30 would seem right getting closer to retirement. As Matt noted, it depends on when you’re retiring and the size of the portfolio.
For example, Suze Orzman has something like 90% of her investments in bonds rather than stocks. Why? Because it’s millions of dollars and she is comfortable with just living off the smaller returns.
Aug 14th, 2008
LAL
I like aggresive moves and buffet still has a very aggressive personal portfolio. I think something like 70/30 in retirement. His take is that it depends on the person, amount to live on, and what you have saved. Also if you have a pension there is less risk.
Aug 14th, 2008
Kevin
Yea, but Buffett is the second richest man in the world and all he does is work on his investments. He’s a professional.
For the rest of us that may not be the best idea, no?
Aug 15th, 2008
Livingalmostlarge
Not necessarily, it doesn’t matter what the number is. What matters is how you draw on it and how long you want it to last. With a 4% withdrawal and assuming you can make 8% with a 70/30 mix you’d be in good shape. With 4% withdrawal and a 5% return you might eat into principal.
Aug 15th, 2008
MITBeta @ Don't Feed The Alligators
The reason for the switch to bonds as you age is to take your profits from your stocks over the years and move them into something safe. When you retire, you should still have some exposure to stocks, but not nearly the 70% some have suggested here.
@LivingAlmostLarge:
You’re supposed to eat into the principal in retirement and die poor. That’s the whole point of the game. Also, have you checked the markets lately? Who’s making 8% this year? This is precisely why if you are relying on your investments to provide income on which to live, you better make darned sure that those investments are safe.
Aug 23rd, 2008
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