According to many financial publications and pundits, one of the most significant decisions an investor and/or financial advisor will make in their portfolio strategy is in determining the overall asset allocation. Perhaps in an effort to simplify (or oversimplify) this decision, some may refer to a traditional rule of thumb and cite to a rule of 100 or 105 minus age as the proper manner for determining asset allocation.
Like any rule of thumb, it may have some superficial appeal and application. However, a top-quality financial advisor will want to know a whole lot more about the customer/investor before simply relying upon this rule of thumb. Many firms and advisors utilize robust questionnaires as well as detailed client interviews to ascertain a client’s willingness to take risk and ability to tolerate any potential losses or consequences of taking risks.
In many examples, a client’s willingness to take risks or ability to tolerate risks is not only guided by age, but also by his or her overall financial situation, family issues, plans for retirement or other lifecycle changes. There really is no one-size-fits-all approach that will work for every investor.
As noted above, an investor’s risk tolerance may be even more important than his/her age in determining a proper asset allocation and investment strategy. An investor’s risk tolerance can refer to both an investor’s willingness to take risk, as well as an investor’s ability or capability of taking those risks. In other words, an investor who is not fully aware of the risks of a particular investment, strategy, or asset allocation may (partly out of trust in the financial advisor, or otherwise) indicate a willingness to take risks, but the investor may not have the financial wherewithal, or be in a position from a lifestyle or lifecycle standpoint, to take the risks (which they may not even be aware or fully comprehend) they are taking.
Depending on age, circumstances, and other factors, a sharp decline in an aggressive portfolio could cause an investor who was misallocated to transform a temporary market event into a permanent realized loss that can have significant impact on their financial lives. Also, simply referring to age ignores other investor goals and objectives. If there are two 55-year-old investors and one is planning to retire at age 60 and the other plans on working past age 70, a recommendation of the same asset allocation to both investors makes little sense under those circumstances.
Additional considerations should also include the investor’s overall portfolio as well as the current and anticipated needs for large expenditures and other living expenses. An investor with an overall portfolio that is 50 times larger than their living expenses and with plenty of other investments, savings, and resources to cover college, housing, medical, or other potential expenses may have a different risk tolerance (even if they are older) than a younger retiree who suddenly encounters unexpected medical expenses. Finally, some investors may have a goal of preserving assets for their children, grandchildren, or for charitable purposes.
While the old rule of thumb may be a good starting place and something to consider, advisors should also take into account whether or not the investor’s portfolio and investment strategy is suitable, designed to meet their individual goals and objectives, or appropriate for them based on the lifestyle, lifecycle, and other considerations as well as projected needs.
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