One investing rule of thumb fails to consider other factors affecting people's risk tolerance
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Just like in many fields, finance has many rules of thumb designed to help beginners or dabblers plan their early efforts to save and invest. Unfortunately, such guidelines are, at their core, one-size-fits-all recommendations — and when you consider factors like market risks, taxes, and individual risk appetites, you should know there’s really no such thing.
One example is the “105 minus age” rule, which essentially recommends that the percentage of an investor’s portfolio placed in the stock market should equal 105 minus the investor’s age. In a recent article on the Wall Street Journal, one finance expert discusses the issues that make the rule problematic.
“[A]n investor’s risk tolerance has two components: the investor’s ability to take risk and the investor’s willingness to take risk,” said Patrick Lach, an associate professor of finance at Bellarmine University and founder of US-based Lach Financial. The rule addresses only half of the problem — and arguably not very well, Lach noted — by using the investor’s age to measure their ability to take risk. Even if an investor is financially able to take risk, they may not have the stomach to withstand plunges in rollercoaster markets, which means they could decide to sell at the dip.
Another issue, Lach noted, is that investors do not have the same retirement date. Even among Canadians, more people are deciding to work longer. So even if two investors are the same age, they may have different retirement plans and therefore would need different stock/bond allocations.
“The final problem I have with the rule is that it doesn’t account for the size of an investor’s portfolio relative to his or her living expenses in retirement,” Lach said. Investors whose portfolios are 40 to 50 times larger than their retirement expenses would be more tolerant of equity-market volatility. Even if those investors are fairly elderly, they should be able to invest fairly aggressively as long as they have enough money left over after expenses, “especially if their goal is to leave their portfolio to their children after they die.”
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A major fund firm's view on retirement planning
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One example is the “105 minus age” rule, which essentially recommends that the percentage of an investor’s portfolio placed in the stock market should equal 105 minus the investor’s age. In a recent article on the Wall Street Journal, one finance expert discusses the issues that make the rule problematic.
“[A]n investor’s risk tolerance has two components: the investor’s ability to take risk and the investor’s willingness to take risk,” said Patrick Lach, an associate professor of finance at Bellarmine University and founder of US-based Lach Financial. The rule addresses only half of the problem — and arguably not very well, Lach noted — by using the investor’s age to measure their ability to take risk. Even if an investor is financially able to take risk, they may not have the stomach to withstand plunges in rollercoaster markets, which means they could decide to sell at the dip.
Another issue, Lach noted, is that investors do not have the same retirement date. Even among Canadians, more people are deciding to work longer. So even if two investors are the same age, they may have different retirement plans and therefore would need different stock/bond allocations.
“The final problem I have with the rule is that it doesn’t account for the size of an investor’s portfolio relative to his or her living expenses in retirement,” Lach said. Investors whose portfolios are 40 to 50 times larger than their retirement expenses would be more tolerant of equity-market volatility. Even if those investors are fairly elderly, they should be able to invest fairly aggressively as long as they have enough money left over after expenses, “especially if their goal is to leave their portfolio to their children after they die.”
Related stories:
A major fund firm's view on retirement planning
Your clients want you to tell them this number
