Monday, 30 November 2020

Asset Allocation By Age: How to Determine Your Ideal Asset Allocation

Asset Allocation By Age: How to Determine Your Ideal Asset Allocation
28 Oct
3:38

Updated on Tuesday, October 27, 2020

Finding the right asset allocation by age is key when creating a personalized, diversified portfolio. Asset allocation is how you choose to divide your money across different investments, such as stocks, bonds, cash and other asset classes. How old you are and what stage of life you are in affect these choices.

We will walk you through how using your current age, risk tolerance and the number of years you have left until retirement as a guide can help with creating a portfolio allocation that’s in line with your long-term objectives.

What is the best asset allocation for my age? Two rules to figure it out

Asset allocation is a personal choice, but your age can play a significant part in how you manage your portfolio. As a general rule, the younger you are and the more time you have to invest, the more risk you can afford to take. That’s because you have a longer window to recover from bouts of stock market volatility, when your portfolio balance may drop significantly.

When choosing an ideal asset allocation, there are a couple of age-based rules you might find helpful:

100 rule

The rule of 100 for asset allocation follows a simple premise: Subtract your age from 100 to determine what percentage of your portfolio you should hold in stocks. For example, if you’re 30 years old, then following the rule of 100 would mean 70% of your portfolio is allocated to stocks with the remaining 30% allocated to bonds and/or cash, which are traditionally considered to be less risky investments than stocks.

Using the rule of 100 can make it easier to choose a target asset allocation. You can simply adjust your portfolio’s stock allocation as you age. There are two potential downsides to this strategy, however. The first downside has to do with managing risk. If you’re 30 years old and comfortable taking on more risk, or you want to potentially build a larger nest egg for retirement, a 70/30 split may be too conservative to reach those goals. You may be better off investing 80% or even 90% of your money in stocks initially, then shifting more of your allocation to less risky investments as you get closer to retirement.

The other issue with the 100 rule has to do with longevity. Living longer means your assets need to last longer in retirement. Following the rule of 100 may not allow for as much growth in your portfolio, as you will need to avoid running out of money in your later years.

120 rule

The 120 rule offers an alternative approach to asset allocation that’s designed to combat the challenge of longer life expectancies. It works the same way as the rule of 100; the difference is that you use 120 as your base number.

So if you’re 30 years old, your asset allocation would now shift to 90% stocks and 10% bonds using the rule of 120. This means taking decidedly more risk in your portfolio. But again, the younger you are, the more you can afford to do so, as you will have more time to recover from major stock market setbacks.

How to determine asset allocation in retirement planning

Asset allocation is something you have to plan for both before you retire and after. There are some ways you can make managing the transition easier.

Target-date funds

Target-date funds, also known as lifecycle funds, automatically adjust their asset allocation over time, based on your target retirement date. These mutual funds are often easy to identify because they typically include the target retirement year in their name. So, for example, if you imagine your retirement will take place in around 2050, you can choose a fund with that date in its name.

If you have a 401(k) or similar plan at work, or if you are funding an IRA, you’ve likely encountered target-date funds. Approximately 90% of defined contribution plans offer them as an investment option. Investing in target-date funds means you don’t have to worry about rebalancing or managing asset allocation, as the funds adjust themselves automatically.

That’s helpful if you’re more of a hands-off investor. On the other hand, it’s important to consider how a target-date fund’s asset allocation over time matches up with your own risk tolerance. An allocation that’s too conservative, for example, could cause you to fall short of your investment goals. On the other hand, as these funds tend to be heavily weighted in stocks when you are far from retirement, you should understand that your balance may fall significantly if there is a major stock market downturn. As always, if you are young, you’ll have more time to recover your losses.

60/40 rule

The 60/40 is another asset allocation option. This rule dictates keeping 60% of your portfolio allocated to stocks with the remainder allocated to bonds. Over time, you would rebalance your portfolio as needed to consistently maintain a 60/40 allocation.

While the 60/40 rule for portfolio-building is easy enough to apply, it’s more generic in its approach. This rule doesn’t take into account your age, when you plan to retire, your investment goals or how much risk you’re willing and need to take on to reach those goals.

Although it could help smooth out market ups and downs, in terms of how your portfolio performs, you could potentially miss out on higher returns over time. That’s a significant drawback to keep in mind when choosing an asset allocation strategy.

What factors may change my asset allocation?

Asset allocation isn’t something you have to make a plan for once and then commit to for life. Instead, how you allocate your portfolio shifts over time.

Beyond getting older, there are other factors that can influence how you invest, including:

  • Early retirement: For example, if you’re interested in joining the FIRE movement and retiring early, then you may want to invest more aggressively during your working years. That could help you build up enough savings to last several decades in retirement. On the other hand, if the stock market experiences a drastic downturn, you’ll have less time to recover, and retiring early may not be doable.
  • Your family: Once you have children, you have to consider items like paying for schooling and other child-rearing expenses. Having kids is just one major life change that might affect how you manage your financial planning, including your asset allocation.
  • Your health: Health is something else to consider. If you expect health care costs to increase in retirement (and they often do), you may need to allocate your portfolio differently to account for that. Or you may want to explore different asset location options, such as a health savings account to save for health care costs on a tax-advantaged basis.

Checking in with your portfolio regularly can help you gauge whether your current asset allocation is still working for you, or whether it needs tweaking. Rebalancing annually can help you keep your investments on track so that you’re achieving the desired mix of risk versus reward. If you feel you need help with your asset allocation plan, you might consider working with a financial planner.

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Source: https://www.magnifymoney.com/blog/investing/asset-allocation/

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