Asset Allocation

Apr 27, 2007 by Adam C. Powell, Ph.D.

How much of my wealth should be invested in stock?

In order to answer this question, you must consider your age and what you would like to do with your investments. The longer you plan on holding your investments, the better off you are investing in assets that are risky, but have a higher likely long-run rate of return. If you are no longer part of the workforce, or soon will be retiring, more moderate investments may be advisable, as if you have a large downswing in your retirement assets, you may not have enough to live on.

How does asset allocation work?

There are essentially two “food groups” of investments; “risky” investments and “riskless” investments. Stocks, options, real estate, and equity in privately held companies are all “risky” investments, while bonds, treasury notes, and certificates of deposit are all “riskless” investments. As you grow older, it is advised that you consume fewer risky investments and more riskless investments. The term “asset allocation” refers to the act of balancing these two groups by slowly transferring money from one group to another over the course of your life.

Although there is no clear science behind it, one rule that is often cited for asset allocation is The Rule of 120. In order to determine the percentage of your portfolio that should be in stocks, take 120 and subtract your age. Thus, if you are 25, 120 – 25 = 95% of your portfolio should be in stocks, and the remaining 5% should be in bonds. If you are 65, 120 – 65 = 55% of your portfolio should be in stocks, and the remaining 45% should be in bonds. While these precise numbers may not make the most sense for your individual situation, they do emphasize that your portfolio should be very stock-heavy in your youth, and more balanced in your later years. Also, note that a purely riskless portfolio is not advised by the rule until you reach 120! The moral of that story is that it is always wise to have at least some stock holdings, or else you may eventually not be able to support yourself if the cost of living increases faster than the returns of your riskless portfolio.

One good way to approach asset allocation might be to re-assess your portfolio every time you hit an age that is a multiple of 5; i.e. 25, 30, 35, etc. By adjusting your allocation every five years, you will assure you are on track without selling and reshuffling your investments too frequently.

What’s wrong with owning a lot of bonds at a young age?

People in their twenties should not own treasury notes and bonds. When you have many years to live, and the ability to earn more income, it is not beneficial to own these instruments as they usually pay a return that is around the rate of inflation. After the capital gains from them are taxed, they make even less sense. Young people usually should be focused on capital acquisition, not maintaining their wealth. It has been shown that over any given decade, stocks are very, very likely to outperform bonds. As this is the case, people expecting to live at least that long, and not depending on their income, can afford to be a bit more risky.

What’s wrong with receiving the vast majority of your retirement income from stocks?

While retired people should own some stocks (perhaps about 45% of the portfolio of a 65 year old, and 25% of the portfolio of an 85 year old should be in stocks), it is not wise for them to own too many. If alternative sources of income do not exist, and it is not possible for the person to return to workforce, it will be problematic if the investments underperform. Thus, the elderly are typically sold investments that have smaller, but more dependable returns.