Investing can be as simple or complex as you want to make it. With literally thousands of funds to choose from and countless individual stocks it’s easy to see how choosing the investments for your portfolio can be a daunting task. On the other end of the spectrum it can be incredibly easy. With the creation of target date funds and other asset allocation funds you can achieve a diversified portfolio by just choosing one investment.
Unfortunately, there’s more to it than that. Think of all the different rules of thumb you’ve heard over the years. You have the 100 minus your age to determine what percentage you should have in stocks. Then there was the 110 minus your age and so on. Then you have some people that suggest you should have just 10% of your portfolio in international stocks and others telling you to put up to 50%. Who is right? Well, there is no right or wrong answer because creating the right investment mix isn’t as simple as looking at your age and risk tolerance and slapping a model portfolio together. There are plenty of other factors to consider.
Thinking About Risk
Everyone has their own risk tolerance and this tolerance generally changes as a person ages or as different life events occur. Typically the younger you are, the more risk you should be comfortable in taking and as you age you generally become more conservative. While this may may often be true, nobody fits into a perfect mold based on age alone.
The main problem people have is not understanding risk and this leads them to invest in a way that is either leaving money on the table or causing them to lose money when they can’t afford to. Most people simply categorize risk as the chance they will lose money but there are many other forms of risk to consider with all investment vehicles:
- Market Risk: The most commonly thought of type of risk. Stocks in the market go up and down so investments in these securities can fluctuate and possibly even drop to zero in extreme situations. This type of risk is easy to see and understand.
- Credit Risk: Fixed income securities like bonds also carry risk. Just because they pay a fixed interest doesn’t mean they are safe. Just like people, companies carry the risk of being unable to repay the lender which could lead to the loss of your principal.
- Interest Rate Risk: Going along with credit risk and fixed securities is interest rate risk. Since many of these investing vehicles require money to be locked in for a certain period of time, interest rate changes up or down can have an effect on your underlying holding and/or mean you are leaving money on the table when higher rates become available.
- Inflation Risk: This is the big one that most people don’t think about. Even if you have a 100% guaranteed investment either through an FDIC insured product or a government issued bond you are still subject to inflation risk. On average, the annual rate of inflation is roughly 3%. This means even if you are earning a guaranteed 4% return on your money you are in reality only earning 1% before taxes. If inflation rises even slightly you are at the risk of actually losing money on a “guaranteed” investment.
Age is Only Part of the Equation
There are many different asset allocation models out there that tell you how you should invest based on your age. Unfortunately, like much of the financial advice out there this is very general and should only be used as a guideline as everyone’s individual situation is unique. Just because a portfolio that is right for most people your age doesn’t mean it’s right for you.
Some people have basic formulas that say 120 minus your age equals the percentage of money you should have in stocks, others say 100 minus your age, and there are even many other fancy calculations you can find on the internet to tell you what you should do. While this general rule of thumb is a good start, it is far from the only thing you should be considering.
For example, these calculations don’t take into account what type of stocks you are holding. You can adhere to the 90% stock and 10% bond rule yet find your allocation either extremely conservative or extremely aggressive. Not all stocks and bonds are created equal and these guidelines do not tell you how to further allocate those investments.
Your Specific Needs Matter Most
Even if you take the time to create the optimal portfolio based on the breakdown of stocks and bonds as well as ensuring it is diversified among those investments it still may be misaligned from your actual needs. Beyond age you need to take a look at your individual situation. Are you single or married? Do you own a home or plan to buy one? Do you have children? Do you have a stable job? What do you plan on doing in retirement?
These are the questions you need to ask yourself. A single 30 year old renting an apartment in a big city with no intentions of getting married, having kids, or buying a house has very different financial needs than a married 30 year old with one child and another on the way while looking to buy their first house. The single person might be in a position to dump every last penny they have in the stock market looking to grow their portfolio as fast as possible while the married couple needs to focus more on safety and security as they try to save up for a house and have to worry about providing for a family and children. As you can see, age plays only a very small role in determining how these people might invest their money.
You Must Adapt as Things Change
The other thing that’s certain is that your needs and goals change over time. In fact, even if your needs don’t change the economy and market climate will and this can also force you to make some changes. A big problem a lot of people have is that they set it and forget it. They create what seems to be a good portfolio and they never touch it for ten or twenty years. While you shouldn’t be fooling around with your investments too frequently you also don’t want to just let it ride forever.
This can be seen in many of the stories you’ve read over the past few years about new retirees who lost a good chunk of their invested money because they were still invested as if they were 10 years away from retirement and the market was on a roll. Now the market reverses and they just retired and realize they were far too aggressive. That’s not a situation you want to be in.
So, it’s up to you to regularly monitor your investments and analyze your situation to see if anything has happened that could force you to rethink your strategy. Getting married, having kids, changing careers, or even external factors in the market and overall economy are all triggers to get you to look over your investment strategy. Don’t be caught by surprise and adapt as changes take place.
What Should You Do?
At the very least you should look at the various allocation models for a starting point. Generally speaking, the younger you are the more you should have in stocks. Just remember that it doesn’t stop there. Take a look at what your actual holdings are to determine the real risk. Then take a look at other aspects of your situation that could affect your underlying investments. Maybe you plan on moving, you could be getting a new job, maybe a child is on the way, a home purchase is in your future or maybe you are shooting for an early retirement to start a business. All of these things are important to consider when creating your portfolio so that you can invest appropriately in order to reach your goals, not just reaching a rule of thumb.
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About the Author: Jeremy Vohwinkle is a Chartered Retirement Planning Counselor® and spent a few years working as a financial planner. Today, he helps people make the most of their money by writing about personal finance here and elsewhere on the web. Jeremy is also Coach at Adaptu and a regular contributor for other publications such as Intuit, and American Express. Be sure to follow Jeremy on Twitter or Google+.