You must have heard the rule of thumb: “Your allocation in bonds should equal your age” or “Your equities allocation should equal 100 minus your age.”
Following the above rule of thumb without taking other parameters into consideration will be dead wrong. This simple advice can cause a lot of problems which will not be as simple to fix. The notion that investment is related to or linked to your age, is too generic to be useful for most investors.
“It’s not what you don’t know that gets you in trouble. It’s what you know for sure that just ain’t so.”
The basic theory behind this advice is based on what might be called the life-cycle theory of investing. It is believed that everyone goes through similar and predictable stages in their financial lives. Accumulating more assets instead of saving in early years, saving more in most productive (high earning) years of middle age, and finally spending their savings during retirement.
Do you see the problem with this theory? This theory assumes two things- first that each and every individual of a certain age acts in a similar way, & second that age is a good indicator of your risk profile. Nothing can be far from truth than the above assumptions.
All people of a similar age act alike? Well not necessarily. Take two 60 year olds. Say one of them has just retired and is planning to enjoy the slow and easy lifestyle now. But the other 60 year old guy is nowhere near retirement and plans to and is able to work and earn well for say the next 10 to 12 years. Do you think that just because they both are 60 years old they should opt for similar kind of portfolio and asset allocation? No, but the age based investing theory says just that.
Let’s take another example of two 25 year olds. One of them started working quite early in his life at the age of 17 and has found his footing and is earning quite well. The second individual has just completed her higher studies and is just starting her career. Now are they at the same level financially and should they be opting for similar asset allocation just because they are of same age?
Even if two people do start their careers at the same time and are at a similar position, age based asset allocation is still not the answer. This is because age is no indicator of risk tolerance. If a 25 year old new investor who is risk averse, is advised to go for a portfolio which is 90% equity, because he or she is at a age where they need to be aggressive, do you think it will be good for him? No, because if within a few months the stock market declines sharply this 25 year old risk averse investor will most likely sell at a loss. And worse he could start avoiding investing for the rest of their lives, because they have low risk tolerance and already have burns to show.
Clearly, portfolios and asset allocation based on age solely are not a magic fit or solution as they are presumed to be. Because, they turn your investment from personal to generic. These kind of portfolios don’t take your personality and financial situation into account. They are just considering your age as a factor and inform you that you should have an aggressive portfolio (high on equities) during your 20s and 30s. Moderate portfolio (mix of equities and debt) in your mid life and finally conservative portfolio (high on debt) after 60s.
The two most important factors – goals and risk profile are completely ignored. A well settled individual of 30 whose only goal is wealth creation can surely go for aggressive portfolio. But a 30 year old person who has more specific goals like buying a car or a home has to be more careful in his investment because he can’t afford as many losses as compared to other investors of their age.
Also, how do you know that 20 and 30 were the most productive years of your life? There are many out there who venture into their own business in their 40s and 50s and earn the most at that age. So just because of their age should they opt for moderate portfolio when clearly their best is yet to come? They have both the capability and tolerance for taking more risk and maybe opting for an aggressive portfolio is best for them.
Every investor is unique, therefore they deserve much more attention and understanding than an easy rule of thumb portfolio. If your financial advisor is giving you cookie-cutter plans it is a cause for alarm. Your portfolio should be based on your current financial situation, goals and risk profile, not just your age.