Principles of Pollex: Investment Allocation

Photo credit: jb

(In case you are confused by the headline: a principle is a rule, and pollex is an obscure term for thumb. We’re talking about Rules of Thumb.)

In this installment of the Principles of Pollex, we address a compelling Investment Allocation Rule of Thumb: Invest X% of your money in bonds, and the remainder in stocks – where “X” is equal to your age. According to this rule, if you’re 35 years old, you’ll have 35% invested in bonds and 65% invested in stocks.

What’s Good About It

Absent any other allocation strategy, at least this strategy provides you with a structure for scaling back your exposure to stocks over time. It’s important to understand that your risk exposure should in general reduce as you reach closer and closer to your goal. This is because you have less time between now and the use of the funds to make up for any downturns.

But you need to keep in mind that once you reach retirement age, you’re not “done”. You have many more years ahead of you (hopefully!) for that investment to support your lifetime spending needs.

In addition to the structure, using such an allocation strategy will require you to be more conservative earlier on in your investing life, and less conservative later in your life, than is likely for most folks. Left to our own devices, we’d be a little more likely to be overly aggressive in the early years (100% stocks, for example) when we ought to have an exposure to bonds to help balance out the portfolio to help us make it through market downturns without losing faith.

In addition, as we start into retirement years, too often we think that we should become totally conservative (100% bonds) when in actuality we have a long time (30+ years left in our projected life) to make the portfolio continue to work for us. With that long-term horizon we need to continue with an exposure to stocks in order to keep up with inflation and have continued growth in the portfolio.

What’s Not So Good

As with all Rules of Thumb, the problem with this one is that it’s too general to be appropriate for everyone – really for anyone. For most people with long-term investing horizons, such as 25 years or more, this allocation scheme is very conservative, and may result in needlessly squelching possible returns early in your investing career.

On the other hand, if you had chosen this sort of allocation scheme, you’d be (likely) much better insulated against significant stock market downturns like the one in 2022 than if you’d gone with a 100% stock exposure.

Additionally, while this rule of thumb does account for your timeline to a degree, assuming that at retirement (let’s say age 65) your risk tolerance and requirement for returns is in the range where a 65% bond/35% stock portfolio will meet your needs. The problem is that this is likely too conservative to meet most folks’ needs over the potential 30 or more years that you need the portfolio to continue meeting inflation and growing.

Lastly, this allocation plan only takes into account the two very broad allocation options of stocks and bonds. A well-diversified portfolio may also include sub-categories of global bonds and stocks, commodities, real estate, and other components that are not so easily “thumbed”.

A Better Way, Maybe?

If you need a rule of thumb, maybe you could take this same one and put in an additional factor to make it not quite so conservative – like adding 25% to the stock factor, and possibly limiting both factors to no less than 10%. So, for a person age 35, you would have a stock component of 90% (100% minus your age, 35, plus 25% equals 90%) and a bond component of 10%. Each subsequent year you’d increase the bond portion by 1% and decrease the stock portion by 1%. At any age less than 35, you’d still be at a 90/10 stock-to-bond ratio. Upon retirement you might reduce the additional 25% factor somewhat – maybe to add only 10%, for example – so that at age 65 your ratio would be 45% stock, 55% bond.

Another way could be to work with a professional financial advisor to lay out a proper allocation plan that is tuned to your own timeline, risk tolerance, and preferences. But if you’re fixed on doing it yourself, this adapted principle of pollex may be useful to you.  You will probably want to put a little more effort into your plan than this – and likely you will over time.