Why age based asset allocation is mostly wrong

I have often heard a lot of financial planners advise an asset allocation strategy based on the age of the investor – something on the lines of invest 100 less your age into equity or similar. While the broad logic of this strategy is that with increasing age, the capacity of an individual to earn himself out of a market crash reduces, purely age based asset allocation might, like many other things in finance and investing, be the right answer to the wrong question.

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A student who has taken an education loan or a young married person saving for the down payment of a house can hardly justify investing 80% of his savings into equity, while a middle aged double income couple with their mortgage paid off or a retired millionaire with 20 more years of life would be foolish to invest majority of their net worth in fixed income. In fact, it would be risky for the youngster to put 80% of his savings into equity if he gets caught in a market crash when he needs the money for his house; and equally risky for the retired old man to depend on his fixed deposits to face 20 years of inflation.

I have found that asset allocation percentages need to be an output determined by life circumstances, net worth, current income, overall risk tolerance and age. Age can be a good determinant of some of the above, but it is too simplistic to assume that it is the only one. In many cases, it is not – and hence, it turns out that portfolios are more conservative or riskier than they should be. Historical data suggests that the possibility of losing money in equities over a 10 year period is quite low. Hence the equity percentage of the portfolio must largely depend on the ability of the individual to, more or less, forget his money and ride out a period of 10 years with no need for the money put in equity (and perhaps, put more into equity, if required during crashes). Now this ability is something that depends on factors like risk tolerance, current income, net worth, temperament and life circumstances, of which age is just one determinant.

The more you have of this ability, the more should your asset allocation be comfortably tilted towards equity. And age has, perhaps, little but not much to do with it.

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