Asset Allocation for different age groups
Investment experts preach it, fund managers endorse it and financial planners follow it like a religion. Yet, the importance of asset allocation is generally lost on retail investors.
Asset allocation is another name for diversification but among different asset classes. It is about how the investments are spread across different asset classes such as equities, fixed income, commodities, forex, and other alternative assets such as real estate, artwork etc. The allocation could be based on one’s age, risk profile, or nearness of goals/investment objectives. It is one of the most important decisions that investors make as the way that assets are allocated among different asset classes are the primary determinant of the portfolio’s returns than the selection of individual securities.
The primary purpose of asset allocation is to earn a return on investment while managing risk. There will, of course, always be market risk (systematic risk)— the risk that an entire market will decline. In the 2008–09 market rout, even the most diversified portfolio took a beating as all asset classes fell in tandem. However, the losses were lower when compared to a portfolio that solely focused on equities/risky assets. The bottom line is that risk cannot be eliminated entirely and clearly savings account isn’t the solution to this, because inflation over time, will outpace the meager interest rates and eventually result in a negative return. The good news is that smart asset allocation can be instrumental is managing some amount of market risk because different categories of investments respond differently to changing economic and political conditions. By including various asset classes in the portfolio, the investor increases the probability that some of assets will provide satisfactory returns even if others decline. Put another way, chances of major losses that can result from over-emphasizing on a single asset class reduces.
Primary Factors to decide the asset allocation Strategy
|. Time Horizon||. Risk Tolerance|
Investment timeline and risk tolerance to a great extent depends on an individual’s age among other factors. In terms of retirement, asset allocation will look very different at the age of 25 than it will at the age of 75. An individual in 20s, can remain invested for 30-50 years before the money is required back, thus more weights can be allocated to aggressive investments such as equities, real estate, commodities etc. that have high growth potential (but also higher risk). Post retirement, one no longer has decades left for the investments to grow and would probably need to withdraw money every year. At that stage, one can’t afford for the portfolio to have a bad year. Therefore, as individuals approach retirement age, portfolios should generally move to a more conservative asset allocation which focuses more on bonds & money market funds to help protect assets that have already been accumulated.
As an example, the S&P 500 declined by 49.2% from March 24, 2000, to Oct. 9, 2002 and by 56.8% from Oct. 9, 2007, to March 9, 2009. Imagine a person in his 70s having invested 100% in equities in any of these periods. Market corrections like these are very problematic -both emotionally and financially. Emotionally, the stress level spikes up and the investor might even get spooked and sell. Financially, selling stocks at the bottom of the market locks in the losses and puts the investor at risk of missing the recovery. Even if the assets are held, the math of market losses is ugly: 50% loss requires 100% gain just to get back to the original portfolio levels. Retirees do not have the luxury of waiting for the market to rebound after a dip. Besides, individuals become more risk averse as they age, given they have less of an ability to generate income. Hence, they are willing to trade lower returns for higher certainty.
On the other hand, had an individual in his 20s or 30s, only invested in bonds, he would have missed out on a massive +2500% rally in equities (SPX) over the past 40 years. Hence, it would always be prudent on the part on the investor to not place all bets in one investment scenario and diversify according to his/her risk tolerance and investment timeline.
How safe one should be relative to the stage in life?
The dilemma is figuring out exactly how safe one should be relative to the stage in life. The classic recommendation for asset allocation is to subtract one’s age from 100 to find out what percentage should be allocated towards stocks/other risky assets.
However, over the past few decades, a lot has changed for the investors. The life expectancy in many developed countries has steadily risen. Not only do individuals have to increase their nest eggs, but they also have more time to grow their investments and recover from any dips. At the same time, U.S. Treasury bonds are paying a fraction of what they once did. As of May 2020, a 10-year T-bill yields less than 0.7% annually compared to upwards of 10% in the early 1980s. Such realities suggest that the old 100 minus your age adage can put investors in jeopardy of running low on funds during their retirement years. As a result, many consultants have modified the rule to 110 minus your age or even 120 minus your age, for those with a higher risk tolerance. Not surprisingly, many fund companies abide by these revised guidelines when assemble their own target-date funds. For example, the Vanguard Target Retirement 2035 Fund geared to investors who are currently in their 50s (as of 2020) has roughly 75% allocated to equities.
Asset allocations for different ages. (For simplicity sake only stocks and bonds have been considered)
20s to 30s: Common wisdom holds that people in their 20s or 30s saving for retirement can load up on risk because they’ve got plenty of time to ride out unavoidable rough patches. Many consultants even recommend all-stock portfolios for this demographic.
40 to 50s: One can continue to go heavy on stocks if saving for retirement as the investment duration is long enough to survive any market turbulence.
50+: Stepping into 50s, a blend of 60% stocks and 40% bonds should do the trick. These numbers can be adjusted according to the individuals risk tolerance.
60-70s: Once in retirement age, an investor with moderate or aggressive risk profile may prefer an allocation of 50% tocks and 50% bonds. While a conservative investor may opt for the 100 minus age rule.
These rules attempt to define asset allocation solely by the investors age. But it’s important to understand that an individual’s financial situation and nearness of goals can be just as important. Any money required within the next 2-3 years should be held in investment-grade bonds with varying maturity dates or in money market instruments. The emergency fund should also be entirely in cash or cash equivalents and this money should be available at a moment's notice.
It’s also important to distinguish between the ability and willingness to take risk. The investor may be willing to take risks, but his financial situation may not permit him to do so. An individual in his 30s, who has just lost his job, cannot invest all his savings in equities if the savings are meant for a child’s education program starting in two years. Meanwhile, if an investor at 60 has sufficient surplus funds and is seasoned enough to stay cool through market cycles, then he/she can go ahead and hold more risky assets. On the other hand, if every market correction strikes fear into the investors’ heart, then probably a more balanced approach would suit the investor. The idea is that asset allocation should provide the investor peace of mind. The investor probably won't have the highest returns on the block but will probably sleep better at night.
Whatever be the case, all these arguments make a strong case for diversified portfolio through smart asset allocation and as Harry Markowitz once said diversification is "the only free lunch in finance."
Data Source: Bloomberg
Arun Leslie John
Chief Market Analyst