Getting older? Admit it when you rebalance your portfolio

Whether you rebalance your portfolio every month, year, or decade ^[4], there’s something else to keep in mind:

You’re not getting any younger!

This can be painful stuff. It’s bad enough remembering your own mortality when trying (/squeezing) on new jeans or racing your kids around the park.

But the fact is our ideal asset allocation will likely change as we get older, too.

This means your age is another factor to consider when rebalancing.

The general idea is to shift your asset allocation as you age. As the policemen look ever younger and the lineup at Glastonbury seems ever more foreign, you want to have ever less of your money in higher risk ^[10] assets such as shares, and more in lower volatility assets like bonds.

This is not because of the increasing risk of having a heart attack if the stock market crashes.

It’s that you’ve less time left to recover from such big falls.

You’re closer to needing to spend your money. Or to be blunt not needing it at all.

How low can you go?

Conventional investment wisdom doesn’t suggest you completely abandon equities as you age. Diversification is still valuable, even if you’re more an old rooster than a spring chicken.

Shares offer some protection from higher inflation over the long term, as well as hopefully stretching your funds a bit further. A 70-year old can expect to live ^[11] for another 15 years, and a sizeable number will live much longer than that. That’s still well within the time horizon for reasonably expecting decent returns from shares.

Of course we don’t know exactly how long we’ve got, which is what makes all this much more complicated than it would otherwise be. The best we can do is muddle through (and remember that Logan’s Run ^[12] didn’t exactly sell the alternative…)

The classic principle governing age and asset allocation is:

• Hold 100 minus your age as a percentage in equities
• Hold the remainder in bonds

If you were 30, you’d hold 70% equities and 30% bonds in your portfolio.

A 70-year old would hold 30% in equities and 70% in bonds.

I’m not sure what you’re meant to do if you’re 101. Maybe pat yourself on the back and order another whiskey!

Actually, as life expectancy has increased, this rule of thumb has been tinkered with. Some people now suggest using 110 instead of 100 in the sums, for instance. But the basic idea is clearly to dial down on shares and add more bonds.

Shifting away from equities as you age isn’t a universal rule, however.

Rules are made to be broken

The high yield equity portfolio ^[13] (HYP) concept is one alternative that was once very popular on UK investing discussion forums.

The idea is you permanently hold a basket of high-yielding blue chips and live off the income. The capital value of the HYP may fluctuate, but the dividend income should be more stable – and potentially even grow – over time.

In recent years, investors seem to have realized they can get similar and probably safer exposure from a basket of well-chosen investment trusts ^[14] or funds, or even higher-yielding ETFs ^[15].

However you do it, the huge downside of trying to live only off the income ^[16] from your portfolio – besides the uncertainty inherent with shares – is you need a lot more money.

Most people end up with far smaller retirement pots than would be required. So they must work on the assumption that they’ll be selling it off to generate an income.

And it’s the uncertainty of the price you’ll get for your risky assets like shares when you need to sell them that is behind the shift into bonds and cash.

Also, this uncertainty compounds. A few bad years as you approach retirement or early on when you’re spending your portfolio can really knock you back. In contrast a few bad years at the end of your life may by that point be irrelevant, since you have more than enough cash to see you through.

Such sequence of returns risk ^[17] is intractable. It also leads to survivorship biases. Someone who retired in the mid-1980s will tell you that keeping all their money in shares was a no-brainer, whereas a 2008-vintage retiree may urge you to swap everything for gold the moment you’ve seen your last pay slip.

(Neither is advisable!)

Retirement researchers have begun to suggest in recent years that the optimal approach might be to reduce your exposure to shares and other risky assets as you approach end-of-work D-Day – but then to actually start to add more shares to the mix again as you proceed through retirement.

Have a read ^[18] and see what you think. I think the maths – and to an extent the logic – makes some sense. But I’d be concerned at betting my one-shot at being retired on a new theory that could be distorted by how returns have played out in the past. The future could be different.

We know that cash and bonds – and annuities for that matter – are relatively lower-risk. Shares can always crash 50% or more in a year.

If you can afford to, I think it makes sense to build the core of your retirement plan around the closest thing we get to knowing in investing.

Live forever?

As Lars Kroijer has pointed out ^[19] on Monevator, if you’re rich things may be different. Your time horizon may extend beyond your own needs – and your death – as you look to provide for a partner, an estate for your loved ones, and even a trust or bequest for a cause you believe in.

The very wealthy ^[20] can create a super-safe income floor ^[21] from low-risk assets. They can then keep the rest in higher-risk investments like shares, property, and the illiquid assets so beloved of the truly loaded, such as forests, paintings, and copper mines in the Balkans.

You’ll need to pony up for advice on how best to do all this, though.

Age and rebalancing your portfolio in practice

However you decide to change your asset allocation as you age, re-balancing time is the ideal opportunity to put it into practice.

Studies suggest that many investors simply set up their investment plans in their 30s and 40s and never touch their asset allocation again.

With the equity portion likely to grow over time and the bond portion comparatively static, this means such investors become much more exposed to equities as they get older. As we’ve discussed, the accepted view is they should become less exposed!

Regular rebalancing at least avoids your portfolio becoming ungainly – and excessively risky. But by making small incremental shifts to our asset allocation over time, we can also tilt towards our desired long run asset mix.

We run our Slow and Steady model portfolio ^[22] this way, shifting 2% of our equity allocation to bonds every year, regardless of what the market does.

Running your own age-related lifecycle fund

Target date ^[23] or lifecycle funds are funds that rebalance portfolios as the owner ages.

They’ve become popular in the last few years, and they promise to mimic what a wealth adviser would do to a client’s portfolio, by shifting the asset allocation as the client ages to less risky stuff.

If you’re managing your own money, you can do the same thing by rebalancing towards your age-related targets over time.

If you know that you want to move from 75/25 equities to bonds to a less volatile 25/75 mix by retirement, then your regular rebalancing could take this into account.

You might allow the overall bond portion to rise by 1% a year, and run down your equity exposure accordingly, for example.

Or you might set hard targets, such as a 50/50 split between equities and bonds when you’re 50-years old, then rebalancing to 40/60 in favor of bonds on your 60th birthday.

This could be a particular apt strategy if you’re keeping things very simple with Vanguard LifeStrategy ^[24] or similar auto-rebalancing funds. But personally, I’d favor a more gradual approach.

What if there’s been a huge bull market in shares and you’re getting very close to retirement?

An investor who was approaching retirement in 1999 would have done very well rebalancing towards bonds just before the dotcom crash. In contrast, an investor of the same age who got greedy and kept running up the equity position could have ended up much poorer.

This is straying into active investing territory. Readers may recall I frolic in it ^[25] personally, but most people (and who knows, maybe me) would be better off following my co-blogger’s purely passive lead.

That’s because is it’s very hard to know when you’re in a truly overvalued scenario. Most purported bubbles are just normal bull markets.

Even missing the early years of what turns out to be a bubble can be detrimental.

If an investor had got nervous in 1996 and sold down his equities, he’d have missed out on much of that great bull market. If he then threw in the towel – and all his money – in 1999 by buying far more shares late to try to make up the difference, he could have blown up his retirement pot permanently.

Following rules doesn’t remove all the risk, but it does lessen the risks of poor judgement and making mistakes.

Age is more than just a number

Ultimately you must make your own decisions about how age affects your rebalancing.

Whatever you decide, just don’t pretend you’re Peter Pan. And remember too that getting old may well reduce your ability ^[26] to juggle assets like a hedge fund manager on Billions.

True, there are some great old investors ^[27]. But the consumer watchdog shows are also stuffed with elderly people who fell for nonsense scams.

One more somewhat depressing reason to reduce risk in your portfolio as you get older.

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Factors that may influence how and when you rebalance ^[5]Rebalance your portfolio for your benefit, not the tax man’s ^[6]