Asset allocation models usually refer to the mix of three asset classes in your investment portfolio: stocks, bonds and cash – although cash is sometimes unwisely lumped in with bonds.
The three major issues in picking an asset allocation model are:
- Goal – What is your investing goal? As the saying goes, if you don't know where you're going, you won't know when you get there.
- Time – How many years will you be investing to meet that goal? Less time means higher risk investments by necessity.
- Risk Tolerance – Can you tolerate higher risk for the promise of higher returns, especially as you near retirement age? Stocks are generally higher risk than bonds or cash, but provide a higher return.
Asset allocation models based on age generally make a few assumptions, which are right for many people but not for all.
- Risk Vs. Age Assumption – Younger investors should take more risks because they have more time to recover if they lose money, and conversely, older investors should take fewer risks.
While generally true, this assumption ignores risk tolerance and investing acumen. Younger investors may take unwise risks, or be too nervous about short-term losses. Older investors may be savvy enough to profit in a bear market.
Give your risk tolerance the proper consideration, and if you cannot handle the risk, scale back your goal appropriately. Don't worry so much about saving for retirement that you die from stress and miss it entirely!
- Starting Date Assumption – Many models assume you have started investing early in life. Experience says otherwise in many cases. Starting late distorts any age-based asset allocation model toward higher risk and stocks.
Again, this may cause you to reassess and scale back your goals if they are not realistic.
With this in mind, let's look at several age-based models.
- Age In Bonds – You simply invest your age in bonds or conservative cash equivalents. At age 20, you have 20% bonds and 80% stocks, with the reverse at age 80. Variations of this model shift the line by subtracting your age from 90, 110 or some other number, then investing that percentage in stocks.
- Target Date – This takes into account how quickly you need to meet your goal, holding a higher percentage of stocks for a longer time. A typical target date model might have you holding 90% stocks through your 30's, ramping down more rapidly to meet with the age-in-bonds line around age 70-80.
- "Flight Plan" – Proposed in a Forbes article in January 2013, this model suggests an early ramp-up as you gain expertise, a "cruising" level throughout most of the prime working years, and a ramp down toward retirement – simulating the takeoff, flight, and landing of an airplane. Where you set the starting levels, "cruising" altitude and time, and rate to ramp up and down, depends on the risk tolerance and needs to meet your goal.
There are many other models online. Any place that you can invest will likely have their asset allocation suggestions on their website, either by age or by level of aggressiveness/risk.
For alternate investments such as real estate (higher risk) and precious metals and cash-value life insurance (lower risk), lump them in with the appropriate risk category.
The American Association of Individual Investors (AAII) website shows typical allocation models by aggressiveness as well as age, and breaks the model down further into stock categories (large-cap, small-cap, international, etc.) and short and long-term bonds. It also shows past performances. This is a great place for the uninitiated to start, although the AAII's overall view is aggressive (conservative investors should hold 50% stocks in their opinion).
Skim through the various online models and see what works for your goals and life situation. Do not be afraid to ask a professional for help if you need it. Investing is too important for random hunches and guesswork.