When it comes to building wealth over the long term, one type of investment reigns supreme: stocks, or ‘equities’. Investors with long time horizons, such as young people saving for retirement, can stomach the volatility of equities, knowing that such high risk will be compensated with high returns over the long run.
However, as an investor’s time horizon shortens – as the person in our example moves closer to retirement – their ability to stomach the rollercoaster of equity returns is reduced. It is then prudent for them to reduce their investment in equities and accordingly increase their investment in lower risk assets such as government bonds.
One rule of thumb for doing this is to allocate a percentage to equities in the realm of 100% minus your age. For example, a 30 year old woman will allocate 70% of her portfolio to equities and 30% to bonds, while a 60 year old woman will allocate 40% of her portfolio to equities and 60% to bonds. The rule dictates that the older woman will have a lower risk portfolio than the younger woman.
At To the pound, we think the rule is a helpful guide in the absence of any additional information. But we might suggest an alteration to the rule to make it more effective. If you are working, and your earnings cover your rent, mortgage and other important expenditures, then, chances are, you don’t need your investment pot to be available to spend. You may have some large planned expenditures such as a wedding or a holiday (see this article), but in generally building wealth, reducing your allocation to equities too early in your life can cost you a considerable amount of money in foregone returns. We would therefore suggest that the 100-age rule only kicks in when you’re quite close to retirement, at about, say, the age of 60. And for those few people (who probably don’t read this blog) who have a considerable pot of wealth already built up, the rule applies even less. That is, only what you’re going to need to live through retirement should be invested in lower risk assets such as government bonds. The rest should be invested in equities. Think of the generation that comes after you – there’s still a long time to go before their retirement.
For more on investment time horizon, see this post, and for more on what really constitutes ‘risk’ to an investor, see this post.
We refer to lots of linked posts in this post. We hope that by following the links you can answer any questions you might have, but if anything is unclear in this post, or you have any questions relating to anything investment-related, please submit comments or questions in the section below and we’ll do our best to answer them.
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