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Your appetite for many things in life changes as you grow older. What you craved when you were in your teens and twenties, you might want less of in your thirties and forties. What you can’t get enough of in your sixties and seventies, you likely wouldn’t have enjoyed in your youth.
As you age, you tend to change your preferences towards many things – and asset allocation in your investment portfolio should be one of them.
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What is Asset Allocation?
Simple asset allocation
For example, a 0,000 investment portfolio might comprise large- and small-cap stocks, bonds, mutual funds, ETFs and other alternative investment classes such as forex and commodities, each in varying percentage allocations.
The illustration above offers a simple asset allocation example. In practice, asset managers consider many other factors to inject diversification into portfolios, such as geographic exposure, industry concentration and sector allocation.
The goal is to make sure that your investments don’t end up in one single proverbial basket. That way, if some investments (e.g. stocks or bonds) aren’t delivering the returns you expect, your other holdings might.
Age Appropriate Asset Allocation
What was appropriate for your investment style and risk appetite when the allocations were first made might not be so today. Market conditions might have changed with time. Your personal circumstances may have altered (marriage, children, divorce, retirement, etc.) or other, more suitable asset classes might become available.
Most appropriately, if there is a sudden shock event in the market, certain assets in your portfolio could suffer losses beyond your current risk tolerance. Sure, markets always bounce back, but at age 60 or 75, you won’t be willing to wait for 10 or 15 years to recoup your losses.
Age-appropriate asset allocation ensures that the assets within your portfolio are apportioned appropriately considering your current age, investment temperament, time horizon, and risk tolerance.
Example: Ideal Age-Based Asset Allocations
Traditional age-appropriate asset allocation theory is centered around what’s known as the Rule of 100:
- Subtract your age from 100.
- The answer tells you what percentage to invest in stocks.
- The rest should be invested in bonds.
A 20-year-old would hold a portfolio of 80% stocks and 20% bonds, while an 80-year-old would have 20% invested in stocks and 80% in bonds. The challenge with the Rule of 100 is that investors are living longer, and fixed income investments like bonds aren’t providing the types of returns they traditionally did.
A one-size-fits-all asset allocation “Rule” is therefore not what modern portfolio builders recommend. Instead, most modern-day portfolio allocation tools look at multiple variables to determine ideal asset allocations. These include your investment time horizon, risk tolerance and behavioral traits, such as what you would do if there was a cataclysmic market event, or how you would feel if you missed your retirement goals by a few years.
One tool at CNN Money allows you to plug in a personalized set of metrics to determine what an age-appropriate asset allocation should look like for you.
Hypothetical asset allocation with low risk
The above snapshot is a hypothetical asset allocation recommendation based on a three- to five-year investment time horizon. If you’re 25 years old, the allocation assumes you won’t need the money until you are between 28 and 30 years old.
If you’re 80 now, this allocation could work if you want the money between 83 to 85 years of age.
Other things being equal (i.e. you don’t mind missing your goals by a few years, and you’d be willing to buy on market dips), the higher your risk tolerance, the lower the allocation recommendations for bonds (safe holdings).
10-20 year time horizon
For investors with a longer investment time horizon (another 10 to 20 years), the asset allocations are different. Once again, your risk appetite will determine the type of assets you should include in your portfolio.
In the above example, if you can tolerate a lot of risk, but can’t afford to miss your time-based goals, then no more than 55% of stocks (35% in large-caps and 20% in small-caps) are recommended. Bump that to 60% if you can afford to miss your goals by a couple of years and are the type to sit tight (do nothing!) in a market downturn.
If you’re a low risk-seeker and are generally skittish when markets sell off, a slightly less aggressive allocation is recommended – more bonds (30%) and fewer stocks (50%).
Age-appropriate asset allocation is essential if you want to ensure that your investment portfolios are attuned with a number of factors as you age. Those factors include your risk-averse/tolerant nature, the time you have left before you need the money and behavioral traits that dictate how you might react to market volatility.
You can find hundreds of tools online to help you create the ideal allocated portfolio to fit your temperament. In general, if you can’t stomach the risk, de-risk your portfolio as you grow older. If you don’t mind embracing risk, tilt your allocation toward riskier asset classes like small-cap and foreign investments.