Two Asset Allocation Rules You Need To Follow At Any Age


Most of us are holding too much cash in our portfolios and not enough stocks, but the worst offenders of all are the youngest investors. This means you, millennials.

A 2014 UBS survey reports that the public continues to avoid the stock market, but that the youngest investors are even more conservative than the older cohort. The survey finds that a typical millennial (age 21-36) holds a whopping 50% of his or her portfolio in cash, only 28% in stocks and the remainder in bonds. Non-millennial investors (older than 36) hold only 46% in stocks and 23% in cash.

This observation flies in the face of traditional allocation wisdom, like the adage to hold ‘100 – Your Age’ in stocks. Typically, we assume that the youngest should hold the most stocks, and get increasingly conservative as they age. The cash-heavy stance of millennials prompts several questions – why are they behaving so conservatively? And what should their allocations really look like?

Since allocation is shown to determine about 100% of portfolio returns, how to allocate investments is the million-dollar question. As we recently discussed, using an allocation framework is what allows you to build a robust, low-fee portfolio out of a few simple ETFs or passive funds. If you’re going to turn to SPY, AGG and other broad index holdings to build out a portfolio, you need to have an allocation plan. Rules of thumb, like ‘100 – Your Age,’ are a great place to start.

But having a single rule of thumb based on age is immediately flawed, because it assumes that age is the only determinant of risk tolerance. It turns out the world is moving beyond the ‘100 – Your Age’ rule, but in two opposite directions.

‘100 Minus Your Age’ Is Dead
The old ‘100 – Your Age’ rule has fallen by the wayside. It had a good run, gaining popularity in the 1970s and 80s as a shorthand for the mean-variance optimization model that came out of Nobel prize-winning modern portfolio theory (MPT) in the 1950s. MPT essentially said, you’re better off holding both stocks and bonds rather than just one or the other. Because they diversify each other, you get more return for the same amount of risk (volatility), or less risk for the same amount of return. While the model requires choosing a target volatility level to figure out the optimal percentage of stocks vs. bonds (i.e. a very abstract process for the average investor), in practical terms it was probably just as effective to prescribe a sliding scale by age and call it a day. But the real world data suggests that today’s investors continue to reel from the financial crisis and allocate far less than ‘100 – Your Age’ in stocks.

Yet while the average investor is holding lower stock allocations, institutional portfolio designers are going ever higher. With today’s low interest rates, investors forgo a lot of return when holding too many bonds – so the recommended percentage of stocks has crept upward in portfolios. The professional investment world is trending closer to a rule of ‘125 – Your Age’ in stocks. We can see this in the growing category of target date funds, which are a good proxy for professional allocation thinking.

Indeed, a look at the three largest target date fund providersFidelity, Vanguard and T. Rowe Price– shows that they all hold much closer to ‘125 – Your Age.’ For example, these three target date funds allocate 90% in stocks for a 30-year old, and about 75-85% in stocks for a 50-year old.

Are The Youngest Investors On To Something?
This stock-heavy approach is all well and good for established investors who have stable employment and a nest egg to rely on in tough times. But it puts the burden of the most aggressive portfolios on the youngest investors – who have the least stable employment and the smallest nest eggs (or more likely, nonexistent nest eggs and student loans to worry about).

A recent paper by money manager Research Affiliates makes a strong case that the youngest investors, who are prone to raiding their savings the most frequently, are burned by high-risk allocations. They argue that this cohort is best served by a “starter portfolio” of 1/3-1/3-1/3 in stocks, bonds, and “inflation securities” like TIPs and floating rate bonds (ETFs TIP and FLOT are good examples). This creates a portfolio of 33% stocks/67% bonds but the “inflation securities” soften the effect of interest rate increases and inflation spikes.

When we factor in the other influences on risk tolerance – existing nest egg and job security – the ultra conservative portfolios of today’s millennials actually start to make sense.

Two Sizes Fit All: Allocation Rules For Everyone
While the general risk aversion of millennials may be justified, sitting on a giant pile of cash is not the way to go about it. And that goes for older investors too –the experience of two major recessions in a decade has been a shock to investor sentiment, but the people who really suffer are the ones who withdraw from the market and stay out even as it marches back upward. When it comes to normalizing allocations across the board, two rules of thumb can cover the needs of most: a conservative starter portfolio for early-stage investors (like that 1/3-1/3-1/3 portfolio of stocks, bonds and inflation securities) and an updated age-based portfolio like ‘120 – Your Age’ in stocks for the rest. Go forth and buy low-cost investments. May ‘100 – Your Age’ rest in peace.

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