How Your Portfolio Should (and Shouldn�t) Change With Age

There’s no shortage of rules of thumb when it comes to investing. A longstanding adage is that 100 minus your age gives you the percentage of your portfolio you should invest in stocks. If that were the case, then setting your portfolio mix would be relatively straightforward since it would only involve changing your allocation by 1% on every birthday.

While this may be convenient, and even logical at first impression, it has one inherent flaw. According to this formula, a 40-year-old investor should have 60% of their portfolio in stocks. This has built-in assumptions that every 40-year-old is identical; assumes they all have the same emotional reaction to a market decline; their cash flow needs are the same, and their financial and retirement goals are the same. If that were the case, then perhaps you could make a justification for a standard formula, but everyone brings a unique set of life experiences and goals to the table. Things would be boring otherwise.

Before we determine how your portfolio should change as you age, we should look at a few basic things about your situation. Ask yourself the following questions:

What is your personal and emotional risk tolerance?
How much experience have you had investing in the stock market?
If the market were to decline, how long would you be able to manage financially?

Question 1: How Much Risk Can You Tolerate?

If you are afraid of skydiving, then it does not make sense to pursue it as a hobby. It is not a declaration of cowardice but rather a personal decision. The same analogy can apply to investing in the stock market. If it makes you very nervous to watch your portfolio fluctuate with regular market movements, then you probably should not be invested in stocks at all (regardless of your age). Doing so could open you up to a great deal of stress and potential losses by selling at the wrong time—like during the panic stage that occurs after a market crash. It is better to make an honest assessment of your tolerance for risk and invest accordingly. From a financial and personal stress perspective, the worst thing you could do is take more risk than you can tolerate.

If you are willing to tolerate risk, then it is appropriate to include stocks as part of your portfolio. How much should you take on? While the “100 minus your age” formula isn’t a universal tool to get you to a specific number, it is directionally correct. Generally speaking, the percentage of your portfolio in stocks should decline with age; however, the exact amount will depend on the specifics of your personal situation.

Question 2: How Much Investment Experience Do You Have?

If you have never invested in stocks in the past, and you have recently retired, it may not be the right time to start investing in the market right now. The fact that your friends and family are invested in the market isn’t relevant to your situation. When retirement starts, you have entered a scenario where employment income has stopped, and you are now funding your expenses from your investments. A market decline is going to naturally cause stress, since it raises the fear of outliving your investments. On the other hand, if you have been investing a portion of your portfolio in stocks for years, then you will have a different perspective. You will face the same market decline in either scenario, but an investor with a long history will be able to tolerate it better emotionally. The financial markets go through regular business cycles, and a long-term investor will have seen several of them. While nobody enjoys watching their portfolios decline, someone with experience knows it will recover if it is invested properly. They are less likely to panic and make the wrong decision to sell during a decline.

Question 3: How Would A Market Decline Impact Your Cash Flow?

This question will be determined by whether you are saving for retirement or are already retired. If it is the former, then technically, a market decline does not have any impact on your cash flow, since you are funding your living expenses with your employment income. In a way, the decline might even be favourable, since you will be making contributions to your investments, and now you can purchase equities at lower prices.

However, if you are already retired, then there will definitely be an impact on your cash flow. You are withdrawing money from your investments to fund your retirement, and a market decline may create a situation where you may have to sell stocks at a loss. To avoid this scenario, it is essential to have at least a minimum amount of your portfolio invested in bonds. This amount is not calculated directly by your age but rather by your expected cash flow needs. If you assume that a large stock market decline could take 2 to 3 years to recover, then you should have at least 3 years’ worth of expected investment withdrawals in bonds (5+ years’ worth would be more appropriate depending on your personal tolerance). For example, if you are withdrawing $5,000 per month from your investments, then 3 to 5 years of projected withdrawals would mean that you should have at least $180,000 to $300,000 in bonds. This would allow you to sell your bonds to cover expenses during a decline, rather than selling stocks at a loss. When the market recovers, you can rebalance your portfolio and switch to your regular withdrawal strategy.

Summary:

Holding stocks in your investment portfolio involves trade-offs. In the long term, stocks will provide a higher rate of return than bonds, and they can help your investments last longer. However, market fluctuations will also create valuation swings in your portfolio. If you have allocated too much to stocks for your personal risk tolerance, then you have created a stressful situation for yourself. If you have too little allocated, then the low returns of your portfolio may cause it to decline faster than you expected. So, if you cannot rely on a standard formula to determine your investment allocation, then how should your portfolio change as you age? Here’s a framework that you can follow:

a. Whether you are saving for retirement or are retired, have a detailed financial plan in place. This should project how much you will need to save or withdraw based on your specific situation. As your life changes and evolves, your plan should, as well. It should be updated every year to reflect any changes to your goals.

b. Make sure you hold enough bonds to ride out a financial storm without selling your stocks. As you get older, the percentage of bonds in your portfolio will likely increase, but it should be based on your cash flow needs rather than your age.

c. Be honest about your emotional risk tolerance. If you have experience investing in stocks and can tolerate market declines, then stocks should be part of your investments. However, if you cannot handle the risk of market fluctuations, then be honest about it. Investing in stocks may not be appropriate for you (regardless of age).

Anwar Husain is an award-winning Finance Professor at the University of Toronto and a Senior Investment Advisor, Wealth Advisor with Richardson Wealth. He is also a published author in several peer-reviewed academic journals in the areas of Finance and Economics. Anwar can be reached at anwar.husain@richardsonwealth.com