Overview
In the world of asset allocation, conventional wisdom dictates that an investor’s age plays a role in determining the composition of their portfolio.
A quick (though arguably, outdated) rule of thumb is to take your age and subtract it from 100. The difference represents the percentage of your portfolio that should be allocated to equities.
A quick google search of “asset allocation” will quickly inundate you with countless search results, with topics ranging from the best portfolio composition for maximum yield all the way to the best asset classes to have in a portfolio.
This is not an article that will discuss the details of asset allocation – there are already countless articles, videos, and books that have done that. Rather, in this article, I will challenge the belief that someone’s age should determine which asset classes they should hold.
The Relationship Between Age and Asset Classes
Asset allocation suggests that a person’s age and ability to take on risk are inversely related. In other words, as someone’s age goes up, their ability to take risk goes down, and vice versa (the younger an investor, the more risk they can take on).
Financial advisors, portfolio managers, and market commentators lament when they hear that an investor is holding a lot of cash, or when an older person is holding lots of equity.
The argument I come across is always the same: young people have their entire lives ahead of them, and can recuperate any losses they suffer down the road, so taking on a very aggressive portfolio comprised mostly of equity and very little in cash is the way to go.
Similarly, an older person does not have enough time to recuperate any major losses, mostly because they will likely need their investments to serve as their primary source of income, whether through dividends, interest, or capital gains.
Admittedly, there is merit to this common wisdom.
No one can deny the fact that the major advantage young people have is the amount of time they have, a resource that everybody can’t seem to get enough of. If a young person suffers a major loss, no problem – given enough time and patience they will regain all that money they lost.
Generally speaking, the investment goal of most seniors is to have their portfolio supplement their financial needs. Older people certainly do not want to jeopardize their financial situations during such a precarious point in their lives.
While these observations are more or less true, I believe that this is too broad of a generalization.
Assumptions vs. Reality
Conventional asset allocation by age makes a few major assumptions.
First, it assumes that every young person has approximately the same risk tolerance. Every young person should hold lots of equity because they all have the guts to handle that risk.
If 1000 people ages 18-24 were picked at random, then conventional wisdom states that all 1000 of them will have no problem taking on the same amount of investment risk. Chances are, all 1000 of these individuals would be told to allocate a large portion of their portfolio to equities.
Building on the first assumption, the second major assumption that follows is that every young person will think rationally. The argument that a young person can simply recoup their losses down the road implicitly assumes that they will make the rational decision not to panic.
A young person can only recoup their losses if they do not dump all their shares, do not succumb to the fear of missing out, and do not make any other emotionally-driven mistakes, which may result in even steeper losses.
Some young people may be able to stomach more risk, whereas others may be very risk-averse. There may be young investors who value peace of mind over superior returns and therefore choose to construct their portfolios in such a way that they can sleep easy at night.
With respect to older individuals, the assumption being made is that almost all of them are risk-averse and that almost all older individuals are passive investors (i.e., do not actively manage their portfolio).
I am willing to wager that there are seniors who still have the skills and temperament needed to continue holding a large portion of their portfolio in equities, options, and other “high-risk” asset classes.
For these individuals, taking a conservative approach makes little sense to them if they have years (or even decades) of experience managing their own portfolio, and continue to have the ability to make wise investment decisions.
Holding “low-risk” assets such as bonds, cash, and bank deposits are a poor fit for a senior investor who still knows how to select high-quality investments and can effectively manage their investment risk.
No Need to be an Expert in Asset Allocation
In my experience, you don’t need to read every book and article on asset allocation to decide how to put together your portfolio. What you do need are two things: an investment paradigm and clear investment goals.
As you may (or may not) already know, the paradigm I adhere to is value investing. The two major concepts that underpin value investing are intrinsic value and margin of safety.
My portfolio is comprised of almost all equities, and very little in cash.
Now, conventional asset allocation wisdom suggests that my portfolio is very high-risk since I have such a huge exposure to equities and no exposure to “safer” assets such as bonds and other cash equivalents.
From my perspective, my portfolio poses very little risk to me because I understand all the companies in my portfolio – their strengths, weaknesses, economic moats, and other details.
In another article where I discussed investment risk, the definition of investment risk is defined as the probability and amount of money lost.
Earlier in 2020, specifically in March, my portfolio was down more than 15%. Many people would point to that and say my portfolio is “risky”, but I understood that the businesses I hold are solid and can continue to generate revenue. Their price drop was temporary because of short-term panic.
Despite my portfolio being comprised almost entirely of equities, because thorough analysis is central to my paradigm, there is very little need to diversify because I understand the sources of investment risk and can manage it.
Having a clear paradigm is only half of the equation. My investment goal is to create a portfolio that will serve as my source of wealth, and the source of wealth for my children and their children, ad infinitum.
Because I plan to have my portfolio outlive me, my investment horizon is technically infinite. Therefore, there is no need for me to hold lots of bonds or cash equivalents if I don’t plan on taking large withdrawals from my portfolio in the first place.
Notice how my current age has no bearing on how I plan to manage my portfolio. The paradigm I adhere to and the investment goal I have in mind influence how my portfolio will look like.
The Importance of Having a Paradigm and Clear Investment Goals
In the articles where I talked about investment paradigms and investment goals, I stressed the importance of adhering to a paradigm and having clear goals.
Once again, I will stress their importance here.
I am able to comfortably hold lots of equities and go against the common advice of holding more bonds and other “safer” assets because I know exactly what I’m working towards, and how I intend to reach that goal.
If a young person knows that they are prone to emotional investing and want to prioritize investment income over appreciation, then dedicating a large portion of their portfolio to bonds and other lower-risk asset classes may be the best course of action, despite the consensus of young people holding lots of equities.
On the other hand, if a 70-year old individual is confident in their ability to assess stocks and do not plan to dip into their portfolio for income, then dedicating a large portion of their portfolio to equities and keeping a low exposure to fixed-income would also make sense.
An investor’s age should not determine the composition of their portfolio. Their paradigm and goals should do that.
Wrapping Up
Asset allocation pundits have argued that an investor should adjust their portfolio composition according to their age.
While there is some merit to this, the assumptions being made are far too generalized, leading to a blanket approach for asset allocation that may not meet the skills, goals, and needs of all investors.
An investor should not immediately defer their asset allocation to the whims of age.
Having a clear investment paradigm and concrete investment goals will make asset allocation a much more personalized experience, an approach that may satisfy the needs of individual investors.
Photo Attributions
