Should my asset allocation change as I get older?
The short answer is yes! And here’s the lowdown on why.
Young people tend to take greater risks in life, which explains a lot of things including why adolescents commit more crimes than other age groups, why they are more likely to drink and smoke and why it costs a lot more to insure a car for a teenage boy than for a 70-something grandmother.
The reason why teenagers tend to take greater risks is less obvious. It is often explained by saying that young people feel immortal and therefore don’t sufficiently weigh up the consequences of engaging in risky behaviour. However, recent research suggests that adolescents make risky judgements because they are in fact more rational than adults, actually taking the time to weigh up the dangers of a certain course of action against its benefits and coming to the conclusion that the reward is worth the potential consequences.
This way of thinking – trading off risks against benefits – is exactly how an investor should approach investing. And just as an individual matures and becomes more cautious in life as he or she gets older, so an investor should adjust his portfolio to become less risky as retirement approaches.
Time horizon is a key factor in the decision-making process when investing. As we all know, more risky investments are prone to greater volatility as well as greater potential rewards. It follows that if you have a relatively short time horizon, you should be more cautious concerning where you put your money.
Take a recent graduate entering the workplace and putting money aside for their pension. They are not looking at touching that money for 40 or so years and can therefore afford to invest in higher-risk funds or stocks because there is plenty of time to recover any losses incurred and a slim chance of being forced to sell when prices are low. Once that same graduate celebrates their half century however, retirement is a lot closer and there is less time to recoup losses. That is why as you get closer to retirement you should re-allocate the assets within your portfolio to reflect this much shorter time horizon.
While as a general rule, tolerance to risk decreases with age there are other factors to take into consideration – a big one being your net worth. The higher a person’s net worth, the more they can afford to lose and their tolerance to risk rises accordingly.
For all of us, the balancing of risk and reward is one of the big challenges of investing. If you need help in finding that delicate balance, please click here and contact me for a review