Financial planning revolves around figuring out the appropriate mix for asset allocation. Various factors affect the amount of weightage given to different asset classes like equities and fixed income, commodities, or real estate, that make up an individual’s portfolio. One of the primary factors that are considered while coming up with a suitable asset allocation is the age of the investor. Your financial requirements and goals might change as you grow older. The key objective behind asset allocation is to maximize return while minimizing risk. As you know, equities as an asset class have a very high-risk quotient, while fixed income or debt are known to be more stable investments. Having the right mix of various investment products within the asset classes lends the portfolio the much-needed diversification that provides wealth appreciation alongside capital protection. It also plays a role in reducing an entity’s tax liabilities, as different types of assets attract different taxation. However, successful investors never lose sight of their financial goals – short-term, medium-term, as well as long-term – that may change over time. Hence, your asset allocation strategy may need to constantly adapt to your new priorities throughout your life. If you are unsure of how to allocate your assets in the most effective way for your unique financial situation, consult a financial advisor who can help guide you through it.
One of the most crucial investment decisions that an individual encounters is retirement planning. A well-planned retirement plan ensures that your daily expenditure, as well as after-retirement objectives, are comfortably looked after. Many rules of thumb have been mentioned that claim to help you figure out how to distribute your total portfolio wealth towards different securities for optimal returns. One of these rules of thumb is the “100 minus age” rule which we will discuss in this article.
What is the “100 minus age” rule for asset allocation?
According to the “100 minus age” rule, an individual may expose a percentage equal to a hundred minus your current age to equities as an asset class. For example, if your current age is 40, the percentage amount you may invest in equities is 100-40 = 60%.
This rule, as a result, indirectly indicates that you should allocate less and less money towards riskier assets like equity as you age and focus more on investments that provide stability of income, albeit lesser in quantum. Capital protection tends to take the driver’s seat as you near retirement age. This phenomenon is referred to as the “declining equity glide path.” The reason behind it is that young investors have the time factor to their advantage to cover up any losses that they might face while investing in risky assets. Additionally, the responsibilities are possibly fewer, which allows them to take the requisite risk to build a corpus. Older investors, on the other end, cannot afford to take the chance of losing their money given you may not have a monthly salary to fall back on during your retirement, and the cost of inflation is likely to erode what you already have saved. You, therefore, want to save as much as possible during the run-up to your retirement so that you may live a prudently comfortable second inning.
Is the “100 minus age” rule a viable rule for effective financial planning?
Although this rule of thumb does prompt the investor to have lower allocations in equity as they progress in their life, it solely focuses on the age factor to come up with allocations. The “100 minus age” rule does not seem to consider other essential elements such as the income-generating capacity, specific goals, current assets, future income potential, and more while coming up with a suitable percentage for asset allocation.
For instance, consider an investor who has a good income-generating capacity or still has a number of work years left even at the age of 55 and plans to start withdrawals from accounts only when required. Such an individual would find investing 60% of funds in fixed-income securities to be a very conservative strategy. They might have a target of earning returns in excess of 5% annually. On the contrary, a person who wishes to retire early, let’s assume by the age of 50, might prefer to divert a significant chunk in low-risk, fixed-income securities like bonds in order to ensure they have enough retirement funds.
The investor might be 62 years old and nearing retirement in another situation. They may wish to use most of their retirement account amount to fund daily living expenses until they reach the age of 70. Taxpayers stand to benefit the more they delay the starting date of their social security benefits. Therefore, the investor might not wish to take chances by investing in equity.
Risk appetite is another factor that the investor should not ignore. An investor who earns a relatively low income at the age of 30 might be risk-averse. They might not be very keen to invest a significant ratio of their portfolio towards risky investments such as stocks or mutual funds.
What do studies show about the “100 minus age” theory?
A lot of research has been conducted to determine if the “100 minus age” strategy for deciding on asset allocation between assets is beneficial compared to other allocation strategies. The 100 minus rule showed the following results.
Some strategies that talk about asset allocation include maintaining a static approach to asset allocation. According to one, you can have a standard ratio like 60% allocated in stocks and 40% in bonds and stick to it through your investment period. The only changes in the portfolio would be annual rebalancing between two types of securities within the same asset class. Your overall 60:40 mix will remain stagnant.
Another strategy suggests using a rising equity glide path wherein you enter retirement with the majority of your portfolio invested in fixed-income assets (say 80%) and keep on spending the income you make from those bonds during your retirement life while letting the stock allocation (20%) grow simultaneously. The stock allocation remains untouched, giving it time in the market.
A recent study concluded that the ‘100 minus age’ rule of thumb delivered one of the worst performances when the stock market is under a downturn. Their study claims an investor would run out of money within 30 years of retirement. The reason for the poor performance is quite comprehensible. Since most of your money is invested in the stock market during your earning years, the underperformance of the equity market will give you low returns, resulting in reduced returns of your overall portfolio on average. There is also the cost of opportunity involved here – had you invested in an assured income product, your money would’ve seen steady growth. In such dire market situations, a strategy like the rising equity glide path may have the capability to deliver better results. That said, there is no taking away the fact that higher exposure to equities may fetch better returns during better market conditions.
The study also researched other asset allocation strategies with several objectives like preservation of capital, generating income, and balanced growth. They found out that all the asset allocation models with the above objectives performed well in strong stock markets.
In summary, the static approach to asset allocation delivered higher account values, and the rising equity glide path offered the lowest account values in the end. Nevertheless, both methods increased the overall value of wealth over time. The “100 minus age” approach delivered a mean performance between the above two options.
A good option for a relatively conservative investor is to go for a bond ladder to plan retirement expenditure. Under a bond ladder strategy, an individual buys bonds with different maturities instead of buying a bond fund. The investor gets definite cash flows at different maturities to fulfill his needs. The risk here comes from the selection of the bonds – investors need to make sure to invest in high-quality bonds.
The right way towards asset allocation for your investment portfolio
There is no straight-jacket method of figuring out the best asset allocation for everyone. You cannot accurately anticipate future periods of market upturns and downturns. Hence, it is best to build a portfolio while planning for the worst and hoping for the best.
After going over the 100 minus age rule, it seems that it might seem to not be the best way to plan for your retirement. It might leave you with insufficient funds for retirement in case of unfavorable market swings. Retirees should instead think over an opposite approach targeting retirement with higher weightage towards fixed income securities and letting the equity segment grow on its own without interference. Such a plan would have less risk and lead to income growth through a gradual increase in equity funds over retirement.
Your personal risk profile and investment goals must be the primary factors influencing your choice of investment strategy. The most practical approach to financial planning is simple- focus on your short-term and long-term goals and be aware of your risk-taking capacity. For instance, assume you have three financial objectives, each with different timelines. If your age is 40 and you have a relatively high-risk tolerance, you can have different allocation ratios according to your goals. You can have all your money invested in debt for a short-term goal. For a ten-year goal, you can half equal the ratio of equity and bonds, and for a long-term goal, you can have 65% in equity and the rest in bonds. If you follow the 100 minus age rule, then you would have 60% of your portfolio invested in equity at the age of 40, leading to entirely different results.
Since there are many investment options and strategies present in the market, it is understandable that an investor gets overwhelmed and thus gets attracted to follow such rules of thumb while investing. However, following such rules blindly could lead to negative results for investors. These rules are primarily theoretical in nature, as we saw under the 100 minus age rule, wherein it assumes that investors that belong to a particular age group are homogenous in their financial positions and characteristics, which is far from reality. Therefore, it is essential to be clear and aware of your risk profile and goals and form a financial plan accordingly.
In conclusion, financial planning is complicated, and it is best to seek help from financial experts. These experts look at your current financial position and your future objective, and based on this information, they model a plan which is particularly suited for you. It is advisable not to follow any rules of thumb before going over every aspect that affects your financial ambitions.
What is the best-suited asset allocation strategy for you to make the maximum of the market potential while keeping your risk exposure under check? Connect with qualified financial advisors who may be able to help you formulate strategies suitable to your risk profile through the Paladin Registry advisor match tool. Simply answer a few questions, and the match service connects you with 1-3 vetted financial fiduciaries that may be able to help you.
Other posts from Paladin Editorial
People spend a lot of time and effort planning for their retirement. They start saving early and find...
Each client has a different expectation from their financial advisor based on their financial goals and investment horizon....
Retirement planning may look like the well-known three-step process – working, saving, and retiring. But there is another...