Is Investment Asset Allocation By Age Rule of Thumb Valid?

by | Portfolio Management

Asset Allocation by Age

Asset Allocation by Age

Asset Allocation by Age is now being questioned by many financial analysts because of changing market conditions and a growing debate on valuation investing vs. buy and hold investing.

Investment Rule of Thumb – Mirror Your Age

The investment rule of thumb that you should mirror your age with your asset allocation (70/30 at age 30, 60/40 stocks at age 40, 50/50 at age 50, etc.) has become so widely accepted that most large investment companies have produced Target Date Mutual funds that coincide with multiple retirement dates. Some advisors are even promoting more aggressive rules of thumb calling for equity allocations of your age minus 110 or even 120!

On the face of it, asset allocation by age seems to make sense and there is empirical evidence that the mirror your age worked well for some periods of time. But rules of thumb have a way of gaining popularity and blowing up as times and markets change. So does asset allocation by age make sense now?

Changing Markets

Expensive bonds and increasing asset correlations are two of the major changes affecting asset allocation investing. Bonds carry significantly more risk than at any time in the last 50 years. Asset correlations have been increasing for years but have accelerated since 2008. In other words, market conditions are different than the time period the mirror your age investment rule of thumb was developed and promoted. The problem is financial advisors are still promoting these and other aggressive rules of thumb. Successful investors need to adapt to changing market conditions and I believe that means questioning the use of these concepts.

Valuation Investing vs. Buy and Hold Investing

There is a growing debate between those who still believe in buy and hold strategies and those who recognize that investment decisions should be valuation-based. Rob Bennett has done extensive writing on this subject and I encourage you visit his website at PassionSaving.com.

One can predict with some accuracy stock market returns over the next 10 years by looking at market valuations. History shows us that the 10 year time periods of poor market performance always come after market valuations have been extremely high. When stock market valuations are low the next 10 years have higher than average rates of return. While it is fruitless to try and time the market in the short term, long term timing is nothing more than buying investments at bargain prices and avoiding owning overpriced assets.

Therefore stock market valuations should be a more important consideration than asset allocation by age. Why would a 30 year old investor want to lose 50% of their portfolio by investing in stocks when they are expensive any more than a 50 year old investor would want to lose 50% of their portfolio? Take into consideration that a 30 year old investor is potentially losing more money than the 50 year old because he has lost principle that would have compounded for many years. Yes, the younger investor has more years to make it back, but the fact remains neither scenario is good. Valuation, instead of age, should be the major consideration in determining your asset allocation.

Does Asset Allocation By Age Make Any Sense?

There is no doubt some consideration should be given to age in asset allocation, particularly those over the age of 70. But I think the evidence is strong that a prescribed rule of thumb does not make sense. Simplicity is always seductive but rarely effective. Investors who desire to take short cuts will most likely wind up getting hurt by rules of thumb that don’t apply to current market conditions, don’t take into account valuations, and certainly don’t account for an investor’s personal situation.

Investors of every age should make valuation the primary determinant of their asset allocation.

Related Reading: Asset Allocation is Dividing Assets To Minimize Correlation

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Disclaimer
While Arbor Investment Planner has used reasonable efforts to obtain information from reliable sources, we make no representations or warranties as to the accuracy, reliability, or completeness of third-party information presented herein. The sole purpose of this analysis is information. Nothing presented herein is, or is intended to constitute investment advice. Consult your financial advisor before making investment decisions.

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