Asset allocation models based on an investor’s age tend to be inherently flawed. They state that young people should be heavy in stocks and old people heavy in bonds. The idea sounds passable, but it doesn’t fit how many people actually act or what they may need.
Age-based models assume all young investors have a high risk tolerance and can emotionally handle bear markets. They also assume retirees should continually reduce equity exposure the longer they’re in retirement. I don’t support either assumption.
The ability of young people to handle high levels of equity is a fallacy. It may be technically correct based on long-term returns, but not on short-term emotion. Many young people have far less appetite for equity risk than the age-based model assumes. This is because they’re inexperienced at taking risk and this often leads to capitulation during a bear market.
I recall my experience as a new investor back in 1982. I was a young Marine Corp officer and had saved a few thousand dollars to put into “something good.” The broker I contacted recommended a popular growth equity fund because the recent performance had been outstanding. What did I know? I bought in.
Within three months my $3,000 investment had fallen to $2,500 and I panicked. To the broker’s credit, he tried to keep me invested. It didn’t help. I recall saying, “Just sell it!” and hung up the phone. Of course, the market went up shortly thereafter and didn’t stop for 17 years. My reaction in the early 1980s isn’t different from what many young investors experience in every bear market.
When a young person takes a high allocation to equity “because that’s what they’re told to do” and then sells during a bear market like I did, it messes them up for a long time. Not only did I feel angry about losing money, the experience created a lingering negative attitude about stocks in general. This kept me from investing properly during the roaring 1980s.
Telling young investors to put all their money in equity often does more harm than good. That’s why I propose a different way of thinking about age-based asset allocation. I call it the flight path model because the allocation to stocks resembles the flight path an airliner would fly. An aircraft take offs, climbs to altitude, cruises at altitude for a long distance, descends into a destination and lands.
A flight path asset allocation works the same way. When a person is young, their allocation to stocks is moderate. Equity allocation increases over time as experience increases. At some point, stock allocation hits a cruising level based on each person’s needs, experience and tolerance for risk. Finally, the allocation descends as retirement approaches and lands at a moderate risk level.
Figure 1 compares three age-based asset allocation models. The first is an aggressive allocation (red) that recommends 100 percent in equity until age 39, then shifts to bonds using 10 percent changes every 5 years (red line). The second is an age-in-bonds model (green) that shifts 1 percent from equity to bonds every year. The third is the flight path model (blue) that builds an equity position over time, holds that position for several years, and gradually decreases a fixed landing position.
Figure 1: Comparing Equity Allocation using Three Age-based Models
Figure 1 illustrates radically different approaches to asset allocation. The high equity positions in the early years of saving using the aggressive model and age-in-bonds model contrast with the gradual climb approach using the flight path model. The models become similar in allocation between ages 55 and 69. This is consistent with the theory that investors should take less risk as they approach retirement. They differ again starting after at age 70. The flight path model does not continue to reduce equity allocation in retirement. Retirees need a consistent equity allocation to provide growth because no one knows how long they’ll be in retirement.
The flight path model fixes two issues that are inherently flawed with other age-based models. First, it gradually increases a new investor’s allocation to equity, which increases the probability that they will stay the course in a turbulent market. Second, since we don’t know how long retirement will be because we don’t know how long we’ll live, the flight path model offers a fixed allocation after retirement.
I believe the flight path model is a better approach to allocation than a straight age-based approach because it fits better with how young investors behave and what retirees need. That being said, this idea is not an end-all solution. Models are a framework for making investment decisions. Each investor should adjust their allocation based on personal needs, circumstances, and their ability to handle risk.