It is common to see investors struggle with allocating their assets to create their desired portfolio. Newbie investors even have it worse. However, this is understandable. As much as the desire to be a profitable investor is a prerequisite, allocating the right asset to your portfolio largely determines how much success this desire can translate to.
There are several models of portfolio asset allocation – age is one of them. In this article, I will be discussing all you need to know about asset allocation, how it relates to risk tolerance, and how to get the right assets on board in line with your age.
That said, let’s start with the key points.
Not everyone would have the time to read this lengthy but interesting article to the end. Therefore, I have handpicked the most important points for your quick view;
- Asset allocation simply means the weight of different investment options in your portfolio, depending on your investment goal.
- Proper asset allocation helps reduce investment risk through diversification and protects investment from market turbulence and timing.
- Portfolio asset allocation can be done using various metrics, including age. Others include time horizon, risk tolerance, income, and financial goals.
- You can allocate assets to your portfolio based on age using the ‘100 rule’ or 120 rule.’
- Redefining your asset allocation may be necessary for the event of new information, lifestyle changes, and wrong risk tolerance assessment.
- Asset allocation is unique for every investor – two investors with the same risk tolerance may opt for different asset allocation strategies.
Introduction to Asset Allocation
We could have different definitions of what asset allocation means. But I find this the most interesting and accurate. Asset allocation is the art and science of mixing your investment vehicles – bonds, stocks, index funds – to create a portfolio that meets a specific goal. It is how much of each investment type you have in your portfolio. So, if we were to assess your portfolio based on asset allocation, we would divide it by percentage into various asset classes.
Let’s give a practical example. I could set up a portfolio comprising stocks, bonds, and cash assets. However, based on asset allocation, I could make it 50% stocks, 25% bonds, and 25% cash equivalent assets. Alternatively, I could make it 20% bonds, 30% large-cap equity, 25% small-cap equity, and 25% cash and equivalents. (These are just examples, not ideal or recommended portfolio asset allocations).
What would inform the weight of stocks, bonds, and other investment options in my portfolio is my investment goal. So, the first step in getting asset allocation right is to have a specific goal, whether short-term or long-term financial goals.
Importance of Asset Allocation
According to Vanguard, 88% of the volatility and returns of any portfolio is determined by the weights of different investment options present in such a portfolio. That means it is an integral part of your portfolio construction. It helps investors strike a balance between their expected returns and acceptable risks.
Whichever asset allocation strategy you opt for, it must answer three questions. The first is where to invest your money. The second is how to invest your money. And the third is how much you should invest. All of these questions help assess your risk tolerance level. Once you know how much risk you can take, all that is left is to set up a portfolio that reflects that risk level.
Having your assets spread across multiple asset classes in line with your risk appetite offers some peace of mind. You can rest assured that your investment is going in the right and preferred direction. It also helps maintain discipline, considering you are not over-investing or under-investing in certain sectors or assets, thereby harming your overall goal.
You already have a long-term and reliable framework to structure a portfolio if you get your asset allocation right. Moreover, it saves you from the dangers of investing based on hearsay.
Role of Risk Tolerance in Asset Allocation
We cannot talk about asset allocation without mentioning risk tolerance. Remember the popular saying “no risk, no return”? Well, it has everything to do with asset allocation.
Let me adopt a simple example to describe what risk tolerance means. If we have a young investor just starting his career, their risk tolerance level will most likely be higher. So, they can allocate a significant part of their portfolio towards equity investments. But, conversely, an older investor nearing retirement has a lower risk tolerance level, so they would favor less risky investment options like bonds.
So, we can conclude that asset allocation helps reduce the risk considerably through diversification. We know the returns of the stock market, debt instruments, and other investment options differ due to market conditions. Therefore, the only way to reach your financial goal is to reflect your risk tolerance in your portfolio. This is exactly what asset allocation helps you achieve.
Interestingly, there is a connection between the trio of asset allocation, risk tolerance, and age. The older you grow, the less risk tolerant you become. So, with every passing year, you are likely to take fewer risks. As a young investor, you can expand your income by switching to better job opportunities. Conversely, an old or retired investor may have only their savings to depend on, limiting them to minimal or no risks.
Important Asset Allocation Questions
We have mentioned that asset allocation is how you weigh your investment options according to how much risk you can take.
But allocating assets correctly requires adequate research. There is no one-size-fits-all approach here. You have to put in work to ensure that your hard-earned money will serve the right (desired) purpose.
You will get asset allocation right if you can answer these questions;
What is your time horizon?
This means how long you want to invest to achieve a set financial goal. The time horizon of every investor differs; it could be months for some people and years for others. However, some investors do not mind waiting for decades to get their desired returns. If your time horizon is long, you may have no problem adopting a more volatile and riskier investment strategy.
What is your risk tolerance?
Perhaps, you are surprised risk tolerance came up again? Don’t be. Your level of willingness to lose some or all of your investment to get the desired returns also count. When it comes to risk tolerance, you can either be an aggressive investor – with a high-risk tolerance or a conservative investor – with a low-risk tolerance. There are also moderately conservative and moderately aggressive investors – two midpoints between conservative and aggressive investors. Then we also have very aggressive and very conservative investors – two extremes of aggressiveness and conservativeness.
How old are you?
Do not mix your age with your time horizon – they are different. You must consider your age when devising an asset allocation strategy. For example, younger investors can go for riskier investment options because they are young and have more time to recover in the event of a loss. This is why a younger investor will invest more in stocks than bonds while an older investor will prioritize bond funds over the stock market.
What is your income?
Your investment power primarily comes from how much you earn. Ensure you appraise your earnings and set up a suitable discretionary income for your investments. You must set a discretionary income that helps you maintain excellent financial health. Investors who are into service or employment often get a fixed salary monthly and are better positioned to allocate savings systematically. However, investors in the business industry may not adopt this model because losses and profits fluctuate. While it is advisable to live within your means, you must not neglect essential expenses like grocery bills, rent, loan repayments, and others just to arrive at a relatively investment capital.
How close are you to your goal?
This question assumes you have financial goals and an already existing financial planning to achieve these goals. The amount of time you have to attain your financial goals will determine your asset allocation. For example, if you plan for a child’s marriage in the next two decades, you can conveniently invest in equity. However, if you have just three years to raise money for your child’s schooling, you are better off prioritizing fixed-income investments with minimum risks to avoid wealth erosion.
What are your current liabilities and assets?
Your assets and liabilities determine what asset allocation strategy you adopt in most cases. For instance, an investor with high liabilities is risk-averse and incapable of taking a high amount of risk, which may add to their liabilities. In addition, knowing what assets you have in your current portfolio can guide your asset allocation process. For example, you want your portfolio to be diversified rather than dominated by certain assets. Assessing your liabilities and assets can protect you from adding more liabilities to your list and help you arrive at a well-balanced portfolio that suits your investment goals.
Asset Allocation by Age – How to Calculate
We have discussed how age plays a vital role in distributing assets in your portfolio. Next, let’s see how this important metric can be your guide in allocating your assets correctly.
Two age-based rules come in handy here;
- The 100 rule
- The 120 rule
The 100 rule
The premise here is simple – subtract your age from 100. What you have as the remainder is the percentage of your portfolio you should allocate to stocks. For example, let’s assume I am a 40-year-old investor; subtracting my age from 100 leaves me with 60. Therefore, I will allocate 60% of my portfolio to stocks and the rest (40%) to cash and/or bonds and fixed income assets.
Reminder: Stocks or the stock market are riskier than bonds and cash/cash equivalents.
This rule makes asset allocation based on age easier. You can set up your portfolio based on this asset allocation rule and adjust it as you grow older. However, it is not a perfect approach. There are two downsides you want to take note of.
First, it may not reflect the ideal risk management level for your age. For example, investing 60% of my investment capital into bonds (and sometimes fixed income assets) is somewhat too conservative. It would take more time to reach my investment goals with this ratio compared to, let’s say, having 80% in stocks instead.
Second, longevity plays an essential role in this rule. If you live longer, your assets must last longer when you retire. But with this approach limiting your portfolio growth, you are at the risk of running out of money if you grow really older.
The 120 rule
The 120 rule helps fix the second downside of the 100 rule, which has to do with longevity. So, instead of using 100 as your base number, you use 120.
As a 40-year-old investor, I would invest 80% (120-40=80) of my investment capital into stocks and the other 20% into bonds (and fixed income assets). Of course, this translates to taking more risks, but why not? After all, I am relatively young, so I have more time to bounce back in the event of a significant stock setback.
Asset Allocation by Age – Risk Tolerance Levels
As noted earlier, there are various risk tolerance levels regarding asset allocations. We can group them into three main classes for ease of understanding – high, medium tolerance, and low-risk tolerance. However, the level of risk an individual can take varies with age. For example, a 40-year-old individual may have high, medium, or even low-risk levels.
The asset allocation by age chart below shows the different tolerance levels of each age group from 20 to 100. Recall our rules. The 120-rule aligns with investors with a high tolerance, while the 100-rule aligns with low-tolerant investors.
|AGE||RISK TOLERANCE (STOCKS/BONDS)|
The medium-risk tolerance falls in between both groups. For example, a 20-year-old investor with a medium-risk tolerance will invest 90% into stocks and 10% into bond funds.
You can assess the performance of the different portfolio allocation models using Vanguard funds on this Vanguard resource page.
Asset Allocation Models by Age
Depending on your age and how much risk you can take, you can find several already-made portfolios that reflect your stock/bond balance. The Larry Portfolio has a 30/70 stocks/bonds ideal asset allocation model. Others include the No Brainer Portfolio (75/25) and the Warren Buffet Portfolio (90/10) portfolio.
Asset Allocation by Age – Redefining your Portfolio
Like most things in life, your asset allocations will never remain unchanged. You should be open to redefining your asset allocation and your portfolio whenever the need arises. What are these needs, and when do they arise?
Certain life events may prompt you to redefine your portfolio. For example, marriages, divorce, and the emergence of kids may all lead to drastic changes in our lifestyles and our financial powers, needs, and goals. The best thing is to adjust your asset spread to suit the new realities when any of these happens.
Your health is another factor that may affect your asset allocations. For example, if you forecast a possible increase in health care costs in retirement, you may need to adjust your portfolio to account for that increase. Alternatively, you may consider other different asset location options, for instance, a health savings account to help you save differently for health care costs while enjoying tax advantages.
Similarly, having new information about your financial journey and status may call for a change in your asset allocation strategy.
If you find out you now have more money than required for your retirement plan or your retirement age is closer than you thought, you should adjust your investment portfolio. Of course, the ideal adjustment would be to leave some portion of your retirement funds for your heirs by switching to a more aggressive asset allocation; after all, the younger generations have a longer time horizon required for such an allocation type.
However, even if you decide otherwise, you must adjust your asset allocation to lower the risk levels to ensure your retirement funds can meet your financial goals without hassles.
Wrong risk estimation
It is common to see people overestimate their risk levels. If not detected early enough, this can be a serious problem, considering risk level is an important determinant of asset allocation. However, once detected, see it as a learning curve. But more importantly, revisit your portfolio and redefine it to reflect your new risk capacity.
Asset Allocation by Age Using Index Funds
When allocating assets, we essentially distribute investment options appropriately in a portfolio. But does this also apply to index funds considering they are mostly diversified already?
Yes, it does. Allocating assets using the age is important even if you hold only mutual funds or exchange-traded funds (ETFs) in your portfolio. However, in this case, we will be talking about diversification in terms of individual company stocks or by market sector. For example, you can choose to invest in utility companies, healthcare companies, and consumer staples if you are looking for more stable index funds. Similarly, you can look towards the financial and technology sectors if you want options that respond better and are more robust to economic cycles.
Interestingly, you do not need so many funds to set up an excellent index fund portfolio. The three-fund portfolio works excellently in most cases. The existing diversification of ETFs and mutual funds offer an advantage here. It means they are less risky and more suitable for investors looking to risk small dollar amounts.
You can also check out this Blackrock resource page for their asset allocation ETFs, which have been on the offering for over ten years. There are four core allocation ETFs, each representing a different risk level. Similarly, there are four ESG Aware allocation ETFs designed for different risk levels.
Target Date Funds
There are also target-date funds and target asset allocation that split your funds between one or two asset classes, while leaving room for regular changes, depending on your target date. Target date funds often comprise exchange-traded funds (ETFs) and/or mutual funds, and are structured in such a way that the assets grow optimally for a certain pre-determined time frame.
The goal of target-date funds is to meet the future capital needs of an investor, and that is where the name “target date fund” is derived. The common timeframe investors use for their target date investment portfolio is their retirement age or timeline, making it ideal for workers’ retirement planning. However, if you are also planning for a future expense, including a child’s wedding or any other goal with a target date, then this is the right asset allocation model for you.
More Resources on Asset Allocation
So far, we have discussed how to allocate assets extensively, particularly touching on age as an important determinant factor. But this is such a broad topic; we cannot exhaust every information here. If you are interested in further reading, I have listed a few useful resources below;
- “Overview, Examples, Strategies for Asset Allocation” – Corporate Finance Institute
- “Beginners’ Guide to Asset Allocation, Diversification, and Rebalancing” – Investor.gov
- “The Intelligent Asset Allocator” – William Bernstein
- “Asset Allocation: Balancing Financial Risk” – Roger Gibson
Our discussion has cut across what asset distribution is all about, why it is crucial, and how you can correctly spread your assets to reflect your risk appetite, time horizon, financial goal, and, most importantly, age.
When it comes to age-based asset spread, you must ensure that your risk exposure reduces as you grow old. However, you should also note that the proportion of equity is an essential component of your portfolio, considering they can fetch you higher returns but at a higher risk.
As a young investor, you will have more equity in your portfolio because of your larger risk appetite. However, as you grow older and near retirement, you want to move away from equity to debt investments. The latter is less risky, although it reduces your potential returns. But who cares? After all, you are near retirement, and you need your money to enjoy your final years.
As a rule of thumb, it is best to invest most in stocks when you are in your peak earning years. This is because you want to prioritize risk over stability. However, as you grow older, and your goal changes to something like retirement planning, the reverse should be the case.
Finally, if you still find it tricky to handle your asset distribution on your own, feel free to consult a registered investment adviser. These professionals can assess the levels of risk you can take and set up the perfect portfolio using the right asset allocation models that suit your situation.