James Stewart of SmartMoney has a must-read article, Why Age Alone Shouldn’t Drive Asset Allocation, refuting one of the mostly widely accepted (and wrong in his opinion and mine) investment adages.
A time-honored investment adage is that your asset allocation should mirror your age: 60/40 stocks and bonds at age 40; 50/50 at fifty; 40/60 at sixty and so on. An entire industry of so-called target-date funds has grown in recent years to help investors implement this simple strategy. Many of these funds, which are a popular option in 401(k) plans, target an investor’s expected retirement date and then allocate and re-balance accordingly.
On the face of it, the logic of increasing an allocation to less-risky and volatile bonds as one gets older seems unassailable. As investors approach and enter retirement, their ability to earn their way out of a stock-market plunge evaporates. So does their ability to outlive a market decline.
So what’s wrong with the allocation adage and the many funds based on it?
Plenty. Like many adages, this one strikes me as grossly simplistic at best, and dangerous at worst.
I don’t know when the age/allocation rule originated, but it must have been a time when bonds were yielding considerably more than the near-zero investors are facing today. The Wall Street Journal ran a front-page article this week illustrating the hardships the Federal Reserve has inflicted on retirees trying to eke out a living from their savings. The 10-year Treasury is yielding a paltry 3.46%, which could easily be eaten away by loss to principal should yields go up, as they surely will someday.
As Stewart points out, interest-rate risk is something that must be considered before blindly increasing fixed income exposure as you age. One of the great advantages that relative strength-driven tactical asset allocation strategies have over target date funds is the ability to keep the portfolio fresh with those asset classes that are performing well and to underweight or eliminate exposure to weak asset classes. Just because fixed income has had a great run over the past three decades doesn’t mean that it will work out so well going forward. In fact, investors should be aware that there have been plenty of periods where fixed income has performed abysmally.