One of the most important financial decisions you will make make is how you allocate your portfolio to different asset classes over time. As you age, you will probably find that your financial priorities will change. The question is: how should your portfolio allocation change with you?
A common approach is to use the “100 Minus Your Age” rule (or “110 Minus Your Age” rule) for your equity allocation. In other words, if you are 25, then you would hold 75% stocks [100 – 25 = 75] and 25% bonds. If you are 50, you would hold 50% stocks and 50% bonds. And so forth. If you used the 110 Minus Your Age rule, you’d hold 85% stocks [110 – 25 = 85] at 25, 60% stocks at 50, and so on.
Another popular solution to this problem is to use a target date fund which slowly shifts its allocation toward bonds as it nears its “target” retirement date. You can see this clearly in this chart from PGIM showing the allocation glidepath for a 2060 target date fund:
Similar to the “100 Minus Your Age” rule, in a target date fund the allocation to equities decreases over time from around 95% in your late 20s to 45% by the time you are 65.
Both of these approaches support the idea that younger people should have more of their money in higher performing, higher risk assets such as equities and that they should become more conservative as they near retirement. The reasoning for this is simple—as we age we have less time to make up for any drawdowns in equities, so we must dial back our risk accordingly.
This is the standard thinking on asset allocation as you age, and it’s not a bad way to go about it. But, if we reframe how we think about risk, we can do even better. Let’s dig in.
Risk In Your Portfolio vs. Risk Everywhere Else
Most of the age-based allocation advice focuses exclusively on the risk we take in our portfolios. However, we know that financial risks aren’t isolated to our brokerage and retirement accounts. Therefore, when we take into account the risks within the larger context of our lives, we can come to some surprising conclusion. And these conclusions don’t always agree with the traditional age-based allocation rules.
For example, instead of having the lowest allocation to equities when you are oldest, you might consider having the lowest allocation to equities when you have the most liabilities. For many people this isn’t when they are 65, but when they are mid-career with a growing family. Yes, a 45-year-old has an extra 20 years to make up for a drawdown, but they also have more mouths to feed in the medium term than a 65-year-old.
If you incorporate big picture risks like this into your allocation decisions, then your asset mix can deviate a bit from the traditional age-based approaches.
Now that we have a better framework for thinking about these decisions, let’s review how your allocation decisions should change across every decade of your life.
Your 20s (Risk Tolerance, Career, and Habits)
Your 20s are where you will likely start your career and your investment journey. This has three major implications for your asset allocation.
- You Can Experiment With Your Risk Tolerance. When you are in your 20s you’ll have the least amount of money you will probably ever have. As a result, investment mistakes are less costly (in absolute terms) than they will be later in life. This means that you can experiment with your risk tolerance without worry. For example, you can decide to go more aggressive, experience a drawdown, and see how you react to it. Did you sell at the first sign of trouble? Or did it not phase you at all? Understanding your risk tolerance is the name of the game here as what you learn in your 20s will guide you for the rest of your life.
- The only thing to watch out for in your 20s is learning the wrong lessons. By chance I went through my 20s without experiencing a major drawdown. I started investing in 2012 when I was just 22 but didn’t see my first 30%+ market correction until 2020 (when I was 30). While I was able to stomach that decline without issue, if I had calibrated my risk tolerance based on what I experienced from 2012-2019, I could’ve made a terrible mistake. While we will never be able to know the future and how we will react to it, keep in mind how your experience differs from history and try to adjust accordingly.
- You Can Focus More on Your Career. Since you should have less money invested in your 20s than later in life, your allocation will matter less than any other point in time. As a result, you shouldn’t obsess over your investments and you should focus your attention on your career instead. Learning about investing (and your risk tolerance) is great, but it will impact you less financially than if you spent that time improving your career and increasing your income. You can prove this with some simple math.
- For example, a 10% return on $1,000 is only $100. This is equivalent to how much I would spend in a single night going out with my friends in San Francisco in my early 20s. My spending and my income are what mattered back then, not my investments.
- In Just Keep Buying, I spoke about this when discussing the save-invest continuum. The save-invest continuum says that you should compare (1) how much you can save in a year with (2) how much your investments can make you in a year. Once you have these two values, focus on the bigger one. In your 20s, the bigger one is almost certainly going to be how much you can save. Therefore, you should focus on your career as much as possible in order to increase your income and save (and invest) more. If you do this correctly, later in life your investments will earn you more than what you can save for yourself.
- You Can Build Great Habits. While the amount of money you save in your 20s may be small (relative to your future savings), your habits can scale as your income grows. What starts as a $25/month deposit to a brokerage account could easily jump to $500 or $1,000/month as your career progresses. While this won’t impact your asset allocation directly, building a regular investment habit will allow you to continually add money to your portfolio and stay on top of your finances. Though I don’t talk about habits a lot, my habit of regularly investing since I was 22 has done more for me financially than anything else. This habit forces me to regularly review my portfolio to ensure that my investments match my long-term goals and intentions.
If you can better understand your risk tolerance, make progress in your career, and build good habits during your 20s, then you will be set up for the big decisions life throws at you in your 30s. For this, we turn to our next section.
Your 30s (Invest for Life Decisions)
In your 30s, your portfolio should be larger, you should have a higher income, and you should have a better idea of your risk tolerance than you did in your 20s. But just when you start to figure things out, you will need to start investing for major life events such as weddings, home purchases, and children.
If you plan on having one (or more) of these events (which are typically accompanied by a large outlay), then you will need to start planning for it. How do you do this? There are two approaches:
- Set aside cash (or something like cash). When saving for a big purchase you should set aside cash or cash-like instruments (e.g. short-term U.S. Treasury bills) to fund them. This is especially true if the purchase will occur within three years. Why? Because, as I have illustrated before, this is the least risky way to guarantee that your money will be there when you need. If your major purchase will be further than 3 years out, then you can consider investing this money into longer-term bonds. And if the purchase is over 5 years out, having some of these savings in stocks can make sense. There is no perfect answer, but as you get closer to the date (e.g. your wedding, your home purchase, etc.) you should reduce the risk of this set aside money.
- For the record, this is the approach I am using to buy a home within the next 3 years. I’ve been rolling short-dated U.S. Treasury bills every few months in anticipation of this. Whether buying will beat out renting within the next 3 years remains to be seen.
- Reduce your portfolio risk until after the life event. Instead of setting aside cash specifically for a large purchase, you could reduce the overall risk in your portfolio, sell on the day you need to fund the outlay, and then re-increase the risk afterwards. I don’t like this approach because it requires you to sell already invested assets (which could have tax consequences) and it takes far more mental effort than a separate set aside cash bucket. However, some people will prefer this approach because they can’t stand not earning as much as possible on their money at all times. While this approach is likely to generate more money most of the time, it is also a bit riskier than the set aside cash approach.
Whatever approach you decide to take, your 30s are about prioritizing. While it would be great to save for a wedding, a home purchase, and children all at the same time, you have to figure out which might come first and plan accordingly. Of course, not everything goes according to plan, but understanding your short, medium, and long term goals should be the focus of your 30s.
And if you reach some of these goals, then you might need to scale back your risk in your 40s and 50s.
Your 40s and 50s (Scaling Back the Risk)
Your 40s and 50s should be the decades where your liabilities (aka your spending) peaks. This is especially true for families with children that still have mortgages to be paid. As a result, during your 40s and 50s you should be taking precautionary measures to ensure that you (and your family) are well protected. These include:
- Having the right insurance. If you are a homeowner, make sure you understand what your policy covers and what it doesn’t cover. There’s nothing worse than thinking you are protected only to find out otherwise. In addition to homeowner’s insurance, consider having an umbrella policy. Bad things happen. The last thing you want is one of these black swans to wipe you out financially. It’s better to pay a premium and not use it than to be underwater because of an unforeseen event.
- Increasing the size of your emergency fund. While it’s okay to have three or six months of spending in emergency fund in your 20s, you should consider moving that up to at least 1 year in your 40s and 50s. This is especially true if you have young children or aging parents that rely on your support. While there is no perfect answer to how large an emergency fund should be, make sure it allows you to sleep soundly at night.
- Reducing your portfolio risk. In your 20s and 30s, your portfolio was likely equity heavy and therefore more volatile. In your 40s and 50s, you should consider reducing this risk to better fit your liability profile. For example you could consider going from an 80/20 stock bond portfolio to a 70/30 (or something similar). The key here is not maximizing your net worth, but maximizing your chance of long-term survival. Unfortunately, many families got wiped out in 2008 because they had fixed liabilities and too much risk elsewhere to cover them. While reducing your portfolio risk is one way to counteract this, keep in mind that if you have a sufficient emergency fund, such a reduction in risk may not be necessary.
Though your 40s and 50s are typically when your liabilities are at their highest, they are also a time when your earnings should be at their highest as well. With decades of work experience and built up skills, most people see their income peak during this period of their lives.
If this is the case, then it can be a great time to increase your investment contributions to help you reach your financial goals. While such a decision doesn’t necessarily impact your allocation, it’s a good reminder that there is still time to save money before reaching the financial end game.
Your 60s and Beyond (The End Game)
Once you reach your 60s, how you should allocate your portfolio depends a lot on your individual circumstances. Unlike 40s and 50s which tend to be liability heavy, the 60s and beyond differ a lot by individual. Everyone has different plans and desires in retirement, so your portfolio should be a reflection of those.
For example, if you want to pass on as much wealth as possible to the next generation, then you should probably take more risk than what is normally advised. If you have lots of liabilities or known health issues, then you should probably take less risk. And so on.
Whatever you do, you should set your portfolio allocation based on the market outcomes you can reasonably expect to experience during your final decades of life. How do we know what to expect in the future? We don’t, but we can use history as a guide.
For example, this chart from Vanguard illustrates the range of historical returns for various U.S stock/bond portfolios going back to 1926:
As you can see, increased stock exposure corresponds with worse losses and better returns. In general, if you want more reward, you need to take on more risk.
How you allocate your portfolio in your 60s (and beyond) should be informed by such results. After all, could you stomach a 35% loss while owning an 80/20 (stock/bond) portfolio? What about a 27% loss on an 60/40?
Your answers will depend on your goals, your income, your spending, your overall wealth, and a host of other factors. If you have low income or lots of liabilities, it can make sense to shift to a more bond heavy portfolio. Since you don’t have the time to make up for drawdowns with future contributions or market recoveries, risk isn’t your friend.
However, if you have significantly more than what you need for retirement, you could consider taking on more risk as a result. It’s ironic because those with more wealth can afford to take more risk than those with less. And it’s also unfortunate because those who take on more risk typically end up wealthier than those who don’t. The rich get richer isn’t a phrase for no reason.
Nevertheless, it’s hard to provide generalized allocation advice for people in the end game because there are so many endings available. By the time someone is in their 60s they could be wealthy beyond belief or struggling to get by. And you would give very different investment advice to each of these people.
This isn’t true for people in their 20s who are more likely to have similar financial situations. I don’t say this as a copout, but as a way of demonstrating that allocation decisions in your 60s (and beyond) are difficult to generalize.
There’s a good reason why retirement and financial planning is a multi-billion dollar industry. If you could solve all your retirement decisions in a blog post, then we wouldn’t need financial advisors or financial planners. But we do because this is complex stuff. Go read Christine Benz’ excellent book How to Retire and you’ll see what I mean.
Whatever you decide to do in the end game, ultimately it has to be the decision that works best for you.
The Bottom Line: Deciding for Yourself
Age is an important factor in deciding what your portfolio allocation should be over time. However, it shouldn’t be the only thing driving your decision. Your risk tolerance, your income, your spending, and much more can influence your asset mix over time.
The big shift in thinking here is to set your allocation based on your life rather than your life based on your allocation. Just because you are 30 that doesn’t mean you should have 70%-80% in stocks. Just because you are 65 that doesn’t mean you should have 40%-50% in stocks. These could be right for you, but it’s difficult to know based on your age alone.
One of the biggest problems with financial advice is that most of it is pitched as a one-size-fits-all solution. But this is almost never the case! In other words, just because everyone else is doing it, that doesn’t mean you should. This is why I’ve argued against maxing out your 401k, argued for some lifestyle creep, and much more.
I got tired of the standard financial advice because so much of it wasn’t applicable to myself and others. The same is true for age-based allocation advice. It’s not bad, but it needs to account for the typical risk profile that someone is likely to face across their lifetime. Once you do this, then your allocation decisions can be far more impactful.
With that being said, happy investing and thank you for reading!
If you liked this post, consider signing up for my newsletter.
This is post 439. Any code I have related to this post can be found here with the same numbering: https://github.com/nmaggiulli/of-dollars-and-data
