Asset allocation is an important tool when it comes to planning for retirement and achieving financial independence. It allows you to carefully balance risk versus reward within your investment portfolio by appropriately aligning the assets within it with your long-term goals.
However, there is an old rule of thumb that is still commonly used to decide how your assets should be split between stocks, bonds and other asset classes that I believe is somewhat outdated for today’s investor.
When you look at your own investments and try to figure out the right asset allocation for you, here's why conventional thinking may be outdated for your situation and what you can do instead to reach financial independence.
The Old Way of Allocating Assets
While no one ever claimed it was a foolproof method for retirement planning, there is a simple way to ballpark what your asset allocation should be based on your age. It’s the 100-minus-age investment allocation rule and it works like this:
- You subtract your age from the number 100.
- The resultant number is the percentage of your assets that should be allocated to equities (stocks).
- The remainder should be devoted to relatively safer investments like bonds or other forms of less risky assets (cds, cash). (For related reading, see: Low vs. High-Risk Investments for Beginners.)
For example, using this method, a portfolio of a 52-year-old would be comprised of 48% stocks and 52% bonds as we subtract 52 from 100. The underlying strategy is to reduce the amount of volatility and risk an investor is exposed to the closer you get to retirement.
And this stands to reason that as a person grows older, it naturally becomes more difficult to recover from substantial losses. If too much of your investment portfolio is apportioned with high-risk assets at the wrong stage in your life, it has the potential to have devastating implications for your financial security.
Why Age-Based Asset Allocation Is Problematic
The first problem with the 100-minus-age rule is that people are simply living longer. As attractive as this greater longevity is in the overall sense, it also means that your retirement income has to last that much longer for you to live comfortably and not run out of money. Second, bonds and other forms of debt don't typically keep pace with the rate of inflation. Therefore, a bond-heavy portfolio can actually cause you to lose money in real terms. Using the age-based asset allocation strategy alone can potentially cause you to allocate too much of your portfolio in bonds in your later years. (For related reading, see: How to Plan for the Longevity Risk in Retirement.)
Lastly, pensions (if you have one) and Social Security don’t guarantee the same level of benefits that they once did. Pensions are either not offered at all or bought out early in the term, while Social Security benefits have failed to increase at a rate that's commensurate with the rest of the market.
Taken together, these factors mean that the growth of your retirement fund will have to come from other sources. In other words, you'll have to work longer or have a portfolio that is carefully constructed and adjusted over the course of your lifetime.
A More Reliable Way to Determine Your Asset Allocation
The bottom line is that the 100-minus-age rule has become outdated and is an insufficient investment strategy to determine how your assets should be allocated within your retirement portfolio.
Instead of looking for a tidy formula for allocating your assets, take a much more personalized approach to retirement planning by asking yourself a few basic questions and revisiting them every few years:
- What kind of lifestyle will you need to support when you retire? Envision the life you want to live in retirement. Where will you live and what will you do? What things do you know you want to be able to spend money on: travel, hobbies, grandchildren, philanthropy? Knowing how you want your life to be in retirement will dictate the investment strategy that will help to support your life in retirement.
- How much income will you need to live this desired lifestyle? Envisioning your life in retirement is the first step. The second is determining how much money it will take to support you, and what is possible based on where you are financially today. Allocating your assets to appropriately align with your specific income needs, not just the age-based estimate, is critical.
- Are you on track with your current investment habits to accumulate a retirement fund that can satisfy these needs? Knowing what you want, then knowing what is possible is what allows a financial planner to help you make smart investment decisions with your money. If you were to continue with your current investment strategy as it stands today, do you have confidence you will achieve financial independence and be able to retire as you envision?
You owe it to yourself and your loved ones to make sure the hard-earned money you invest is appropriately allocated to meet your true retirement needs, not just a general ballpark idea.
(For more from this author, see: If You're in Your 30s, Will You Be Able to Retire?)
To learn more about working with a financial advisor, you can download our free guide, The Ultimate Guide for Choosing Financial Advice.