Beyond the ‘100 minus age' rule for equity

What proportion of your portfolio should be in equity investments? Some follow “100 minus age” rule to allocate money to equity. That is, if you are 30, you should have 70 per cent in equity. This rule is logical- your ability to take risk presumably reduces with age. In this article, however, we first show you why you should be cautious while applying this rule. We then offer you some pointers you can consider while planning your asset allocation.

Situation matters

The proportion of equity in your portfolio is a function of your risk appetite. And that, in turn, is a function of your ability and willingness to take risk. Below, we explain why you have to be careful before you apply the “100 minus age” rule.

First, what if your active income is uncertain? If you work in an industry that is highly cyclical, you should not have too much equity in your portfolio. Not even 100 minus age! This is because your active income is risky. Your investment should be stable, compensating for your risky income. So, you ought to invest more in bonds.

Second, what if you are old and are investing a significant proportion of your portfolio for your children? You could have more than “100 minus age” in equity for the investments earmarked for your children. The reason is that your children have longer investment horizon and higher ability to take risk than you do.

Third, what if you have just retired and are in good health? You may enjoy a longer post-retirement life. So, assuming that you retire at 60, having just 40 per cent in equity (100 minus age) may not suffice. This is because a portfolio that contains 60 per cent bonds cannot generate enough income to sustain your post-retirement lifestyle for a long period, adjusted for inflation.

That said, how should you decide the proportion of your equity investment?

Allocation pointers

Professional wealth managers and advisors use optimisation models to arrive at the asset allocation. Suffice it to know that such a model inputs your requirements, investment horizon, risk tolerance, initial investment and periodic capital contributions, to arrive at an optimal allocation.

But how can you decide your allocation without such sophisticated models? Below, we give some pointers that you can consider. Bear in mind that these pointers are not substitute for the model, but are better than ad-hoc decisions.

First, if your investment horizon is less than 5 years, do not consider equity investments. This is because you have limited time to recover losses should equity prices decline in the first or the second year of your investment.

Second, consider equity allocation between 50 and 75 per cent. This allocation includes both equity investment that you will hold till your investment horizon and the one that you will create to capture short-term profits. The former is part of your core portfolio and the latter, part of your satellite portfolio.

Third, if you are undecided on how to plan your equity allocation, start with an allocation of 63 per cent. This is half-way between 50 and 75 per cent! Remember to gradually reduce your equity allocation as you approach your investment horizon.

Fourth, if you have high taxable income, you should prefer tax-efficient investments. Bond investments are taxable, both interest income and capital appreciation. Equity investments, on the other hand, are tax-exempt, if held for more than one year. You may, hence, want to consider more than 63 per cent equity allocation.

(The author is the founder of Navera Consulting, a firm that offers wealthmapping and investor-learning solutions. He can be reached at >enhancek@gmail.com )

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