Save, Invest, Build Wealth

Best Asset Allocation Based On Age & Risk Tolerance

By in Advanced Investing, Asset Allocation, Investing, Reader Question | 14 comments

How To Figure Out the Best Asset Allocation For You

Graham from Moneystepper asks;

What metric (rule of thumb) would you recommend for asset allocation based on age and risk appetite?

Graham’s question is not as simple as it might seem. Let’s attack it from several investment angles and throw in a bit of research as well.

Quick Primer: What Is Asset Allocation?

best asset allocation

 

The asset allocation decision divides total investable funds by percent into specific investment categories. An asset allocation represents the investor’s choice of broad asset classes and the percentages distributed across the categories.

The two most common asset classes are stocks and fixed, which includes bonds and cash.

Based upon the seminal study by Brinson, Hood, and Beebower, “Determinants of Portfolio Performance”, from the August 1986 Financial Analysts Journal, asset allocation is widely considered the largest contributor to a portfolio’s return.

In other words, the individual stocks, bonds, and funds you choose or when you buy or sell is less important to your ultimate return than the percent allocated to various asset classes. That still doesn’t answer the question, “What is the best asset allocation for you?”

If you invest in a diversified mix of 50% in stocks and 50% in bonds, your return will closely approximate the market return of 50% stocks and 50% bonds.

Asset allocation is very important  because  it creates portfolio diversification and reduces an investment portfolio’s risk.

Click here for top notch beginning – advanced investing courses.

Adjust the Classic Asset Allocation Advice

The classic asset allocation advice is very simple:

Take your age and subtract it from 100. Then invest the resultant percent in stock assets with the remaining percent in fixed assets.

If you are 40 years old, according to the classic advice, you should have 60% in stocks and 40% in fixed assets. Like the graph above. (100-40 years old=60% stock assets)

We’re living a lot longer than in the past. That’s why the updated idea is to subtract your age from 120 and use the remainder to invest in stocks.

If you’re 50 years old, subtract that from 120 and you’re left with 70. So the new thinking suggests a typical 50 year old should have 70% of her assets in stock investments and 30% in bonds.

This advice is a good starting point, but incomplete.

Know Your Risk Tolerance

The historical wisdom suggests that if you are young, with many working years ahead, you are more risk tolerant. This theory goes on to imply that if you suffer a big loss in your investment portfolio at age 30, you have many working years ahead to replace the lost funds. Thus, younger investors are typically advised to own more stocks and less bonds since stocks offer the prospect of greater long term returns (albeit with more risk).

What happens when the market tanks?

Your portfolio = 70% Stocks and 30% Bonds

Imagine this scenario, it’s the end of 2008, you are 30 years old and your investment portfolio holds 70% stock mutual funds and 30% bond mutual funds. Your stock funds fall 33.8% (Dow Jones Average 2008 loss), the worst drop since 1931, according to an ABC News report. (And if you were especially unlucky, your General Motors stock fell 87.1%.)

2008 is an example of stomach churning investment losses.

Fortunately, the bond portfolio (proxy; Barclay’s aggregate bond index) returned 5.24% in 2008.

Thus, if you invested 70% in a Dow Jones index fund and 30% in a diversified bond index fund, your return in 2008 would have been; -22.09%. ((.70 x -.338) + (.30 x .0524))

If you had a $25,000 portfolio on January 1, 2008, on December 31, 2008 the value would have fallen to  $19,478. In 2008, $5,522.50 of wealth would have vanished in one year.

Although a 22% loss isn’t great, it’s a better return than that of an all stock portfolio.

Had your stock fund been invested in a broader market index, the Standard and Poor’s 500 in 2008, your stock allocation loss would have been a whopping 36.55%.

Consider a ‘worst case scenario’ and do a gut check. 

Regardless of your age, if you are extremely risk averse and cannot tolerate drops in your portfolio value, you may want a greater percentage in fixed/bond assets and a lesser percent in stocks.

Michael Kitces, a well known investment advisor and prolific writer alleges that risk tolerance is stable and can be measured. He recommended in a blog post as well as a recent twitter exchange, a risk assessment tool at Finametrica (free trial available). Index Fund Advisors also has a risk quiz I’ve tried (be prepared for a quick registration and follow up phone call).

If you want a quick and easy risk tolerance measure, try my (non-scientific) Sleep at Night Guide to Risk:

Risk Guide-Find out your risk tolerance

Your age does not necessarily correlate with your risk tolerance.

Many younger folks cannot handle all but the smallest declines in their investment portfolios. Thus, the more risk averse investors need a greater percent in fixed assets.

What Is the Best Asset Allocation Based On Age and Risk Tolerance?

The best asset allocation for you should consider your age, risk tolerance, how long you expect to work (your human capital) as well as where you work. If you work in the investment industry, you may want to direct a lower percent towards stock investments. That’s because your job is dependent upon the financial markets. You do not want to experience a drop in your stock portfolio and a layoff because the market tanked.

If your income is erratic or uncertain, be sure to ramp up your cash investments.

Asset Allocation Action Steps

1. Spend a bit of time understanding yourself and the markets. If you’re interested in an excellent 100 page book on investing, I recommend The Elements of Investing, by Malkiel and Ellis.

2. Take a risk tolerance quiz and assess how you will feel when your portfolio experiences an inevitable cyclical decline.

3. Create an asset allocation considering your age, risk tolerance, security of your job, and industry. If you’re job is insecure, you want lesser amounts in stocks and bonds and more in cash assets.

4. For more on this topic, click the link to read my free ebook: How to Invest and Outperform Most Fund Managers.

free investing book
 

What is your age and asset allocation?

A version of this article was previously posted, comments remain.

    14 Comments

  1. Wow – thanks Barbara – what a great answer. I love your “sleep at night” guide.

    I have a strange mentality where I am annoyed when my investments fall in the year. However, if they fall 5% or 30%, my mentality is pretty much the same. I think that probably makes me a “C” from this test.

    Currently, I’m much more aggressive that my age suggests (with about a 95% to 5% stocks-to-cash ratio).

    However, I’m this aggressive with this part of my portfolio as I also have income generating property investments.

    Final question: how do you place other investments (property for example) into this asset allocation split?

    moneystepper

    February 24, 2014

  2. People should consider Market Crash Insurance through buying out of the money puts to on SPY Index, this way when the market crashes you have protection on the downside – What do you think Barbara?

  3. @Moneystepper- Actually, you can calculate your overall asset allocation by including your real estate in the pie. That will automatically reduce the percent in stocks and bonds and increase the percent in real estate. For example if your overall net worth including your real estate holdings is $100,000 and the real estate equity is $35,000 or 35%, then your stock allocation would only be $61,750 or 61.75% and your cash percent would be 3.25% or $3,250.

    I would make sure you have enough cash available for emergencies as well.

    Barbara Friedberg

    February 24, 2014

  4. Hi Nick,
    For those who don’t know what a put is;
    An option contract giving the owner the right, but not the obligation, to sell a specified amount of an underlying asset at a set price within a specified time. The buyer of a put option estimates that the underlying asset will drop below the exercise price before the expiration date. This gives the option holder “insurance” against a market crash.
    The SPY is a proxy for the S & P 500 index.

    My personal opinion is that the cost is generally quite high to purchase put options when markets are bordering on full or overvaluation.

    My personal opinion, and not advice for anyone else is this. As I don’t need my investment portfolio for at least 10+ years, I prefer to wait out the market declines.
    I also tend to like the security of holding a large cash position as well.
    Are you buying Spy put options? If so, what maturity date are you looking at?

    Barbara Friedberg

    February 24, 2014

  5. @ Barbara
    Hi Barbara, thanks for replying. I usually buy OUT OF THE MONEY puts which are very usually 0.5% of portfolio of $100,000. Simulations suggest that as markets make a sharp decline the volatility in the SPY puts rises, it is not uncommon to see a 0.25 Cent OTM SPY Put rise to $3 or even $4.

    At the moment I am not buying SPY Puts but it is something I will consider in the future to protect my portfolio.

  6. Hi Nick, Thanks for the color. I would love for you to write a post for my more advanced readers about this strategy and how it might play out when a market correction occurs. Also, when you buy the puts, how far out do you typically go and what’s keeping you from implementing this strategy now?

    Barbara Friedberg

    February 25, 2014

  7. I really like your section on risk tolerance. You did a great job explaining the reasoning behind the classic advice and why it may not be correct. Thanks for your clearly stated insight!

    Leonard @ The Wallet Doctor

    February 25, 2014

  8. Refreshing to hear someone finally say that your risk tolerance doesn’t correlate with your age. I am in my 20’s and I have several peers who don’t want to take on very much risk with their investments. So even despite that what is your personal leaning regarding risk? What is your current asset allocation.

    Jon@2-copper-coins.com

    February 26, 2014

  9. @ Barbara

    Hi Barb, thanks for the offer. It would be an honor to write for a great blog like this. When I buy Puts I look at historical data during market crashes. What I found was that the market could correct between 25% and 40%. I then choose the strike prices according to this correction so Out of the Money Puts become In The Money.

    At the moment I am waiting to see if the S&P 500 1840 level holds. If the resistance becomes support I will not buy OTM Spy Puts.

    Also I don’t see any clear and present danger presented to stocks at the moment that would create a panic sell off. There is always anxiety in the market but this is normal, I keep observing the market diligently and when I see trouble I usually start accumulating the puts slowly but surely.

  10. I’m aggressively positioned with 80% equites and 20% bonds. I’ve got a mixture of index funds: large-cap, mid-cap growth, small-cap growth, and an International growth funds. I agree with you Barb that your risk tolerance is crucial in designing your allocation. If you have little risk but are invested in assets that are volatile, you may be more likely to make buy/sell decisions based on emotion and that will hurt the potential returns generated by your portfolio.

    Paul @ The Frugal Toad

    February 26, 2014

  11. Good article, as usual, Barbara. As retirement nears for me and my wife, we have moved our asset allocation (AA) to near 50/50. With the 2013 stock run up, our AA is closer to 60/40, and I am OK with that. I am using new contributions to rebalance toward our desired bond allocation.

    Bryce @ Save and Conquer

    February 26, 2014

  12. @Leonard-Question, why do you think you may not be correct?
    @Jon-My personal risk tolerance is conservative to moderate. My approximate asset allocation is (most asset classes are in index funds) 20% international stocks; 20% US stocks; 8% REITs; 3% risky peer to peer loans; 30% cash; 19% bonds (including 4% in TIPS and I Bonds).

    Barbara Friedberg

    February 26, 2014

  13. Great post Barb and sound info as always. I agree that age is not the only measure of risk tolerance. That is one reason I’m not a big fan of Target Date Funds for folks within say 20 years of retirement.

  14. Great post Barb and sound info as always. I agree that age is not the only measure of risk tolerance.

    Marie

    December 20, 2015

Trackbacks/Pingbacks

  1. Should I Invest In a Target Date Mutual Retirement Fund? | Barbara Friedberg Personal Finance - […] there is a widespread presumption among many individual investors that investment risk tolerance automatically declines with age, this is…
  2. Tactical Asset Allocation; What To Do With Investments? | Barbara Friedberg - […] that you lower your stock allocation from 70 percent to 30 percent and that prices continue marching upward for…
  3. Are Target Date Funds Good or Bad? | Barbara Friedberg - […] blindly invest in a target date fund and go to sleep for the next 30 years. You should consider…
  4. The 54 Best Personal Finance Tips of 2014 | Debt RoundUp - […] Read more about this tip […]
  5. How to Choose Mutual Funds? Reader Question - […] considering how many and what type of funds to choose, you must figure out how much volatility or risk…

Post a Reply

Your email address will not be published. Required fields are marked *

This blog is kept spam free by WP-SpamFree.