It is believed that 14th century Dutch carpenters used the width of their thumbs to estimate an inch of distance. Since then, the concept of a ‘rule of thumb’ has been used to get a sense of how to do things for centuries. When buying a belt, get two waist sizes larger. Arrive at the airport at least one hour before your flight. You will be just fine drinking milk five days past the ‘sell by’ date. Day six: death. The number of helpful examples is endless but, unfortunately, the practicality of many are limited.
Rules of thumb have been applied to investment allocation as well, and sometimes to a fault. Until recently, many believed that the percentage of growth assets (stocks) in your portfolio should equal 100 minus your age. Very simply put, a 20 year-old should have a portfolio that is 80% stocks. A 60 year old should have a portfolio of 40% stocks. One new rule of thinking changes the math a bit and uses 120 as the starting point. That seems too easy, right? No matter which methodology you like, we prefer to take a more personalized approach to your investment strategy.
Every investor, every investment goal, and every level of risk tolerance should have a custom allocation. Our aim with an investment portfolio is to achieve the level of growth needed to reach your goal, to do so without taking unnecessary risk, and to accomplish that goal with a reasonable amount of savings/contributions. Some of the key inputs in choosing an allocation include:
- Length of investment timeframe
- Required growth rate
- Attitude toward risk, a.k.a. risk tolerance
We understand that stocks have most often been the vehicle of growth in an investment portfolio, but stocks should be used sparingly in a portfolio that has a short-term timeframe or cannot experience loss. For example, if you are saving for a mortgage down payment, you can’t take the risk that the stock market declines right before you plan on making a purchase. You want it to grow, but you absolutely need it to be there. You wouldn’t want to explain to the bank that you lost your down payment in the stock market. In terms of retirement planning, the idea of the “120 minus your age rule” is on the right track, but we can do better than that. Younger investors can keep a higher portion of their retirement portfolios in growth assets because they have a longer timeframe to ride the ups and downs of the market. Additionally, their annual contributions represent a much larger percentage of the portfolio. Younger investors can ‘save’ their way out of some volatile markets in the early years.
As investors approach their late 40s and 50s, the retirement picture begins to look a lot clearer. Many have reached their peak earning years and have a better sense of the lifestyle they want in retirement. Many financial advisors revisit the allocation topic by performing analysis that shows the amount of sustainable income a client can expect. Various asset allocations can be simulated to see which is the best combination of safety and growth. If you have done a diligent job of saving, you may have afforded yourself the luxury of having options. You might not need a lot of growth and can therefore reduce your risk. If saving wasn’t your forte, you may need to keep an aggressive portfolio but also aggressively save (and maybe sell the jet skis). One thing to remember is that trying to grow your way out of a financial hole is not likely a reasonable solution. With additional growth potential comes additional risk. Think of your allocation like the speed you drive your car. Going the speed limit will get you to your destination. Five miles per hour over the limit may make the bumps harder but will get you there a little faster. Fifteen miles per hour over will probably end badly!
Jon McEvoy is a Portfolio Manager with Johnson Investment Counsel (“Johnson”).
The views and opinions presented in this article are intended for entertainment and educational purposes only and should not be construed as a solicitation to effect transactions in securities or the rendering of personalized investment advice. The views and opinions expressed in this article are not intended to be tailored financial advice and may not be suitable for your situation. No person should assume that any advice or strategies presented in this article serves as the receipt of, or a substitute for, personalized individual advice from an investment professional. You should consult with a professional before taking any action inspired by the views and opinions presented in this article.