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Asset Allocation By Age : A Rule of Thumb to Forget?
Asset Allocation by Age has experienced various amounts of popularity through different time periods. Financial planners and Wall Street have joined together over the years to promote rules of thumb and products such as target date funds that have produced mediocre results at best.
Investment Rule of Thumb – Mirror Your Age
The investment rule of thumb in which you 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 many
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 subtracting your age from 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 rule of thumb 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?
Longer lifespans, the most expensive bonds in history, near record equity prices, and increased asset correlations are changes affecting how you should allocate your assets. 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 heavily promoted.
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.
Bonds carry significantly more risk than at any time in the last 50 years. Investors who buy into bonds at today’s prices are accepting low rewards (yield) and high risk to their principal. Bonds may carry more risk than some equities today.
Furthermore, investors who employ buy and hold strategies that include indexing are putting large percentages of their portfolio in equities at prices that historically promise low or even negative returns over the next 20 years.
Further complicating the issue is the fact that life expectancy continues to increase. Every investor should be concerned about losing large amounts of their principal. This by itself makes asset allocation by age less relevant, at least until investors reach ages that are far beyond initial retirement ages.
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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.
One can predict with some accuracy stock market returns over the next 20 years by looking at market valuations. History indicates that 10 – 20 year time periods of poor market performance come after market valuations have been extremely high. On the other hand, when stock market valuations are low the next 10 -20 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 attractive 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 overpriced assets 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 principal 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 not always 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.
Asset allocation by age is a flawed rule of thumb. Increasing lifespans, expensive bonds and stocks, and increased asset correlation should cause investors to be skeptical of this rule of thumb. Capital preservation should be the primary focus of every investor. Investors of every age should make valuation the primary determinant of their asset allocation.
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Additional Reading: 34 Investment Strategies and Rules to Make You a Better Investor.
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