In a previous article here, I took a brief look at what lifecycle investing is. In this article, I will take a deeper look at this type of investing with two broad guidelines.
Two common approaches in lifecycle investing come from the popular rule of thumb of “100-minus” and Burton Malkiel’s A Random Walk Down Wall Street.
Firstly, let’s look at the “100-minus” rule.
Most investors would be familiar with the “100-minus” rule. Simply deduct your age from 100 and the remainder should be invested in equities. If you are 30, then 30% of your portfolio should be in low-risk or risk-free assets such as fixed income bonds and 70% allocated to equities.
Next is a slightly different perspective.
Burton Malkiel takes a far more prescriptive approach. An investor in her mid-twenties should allocate 70% of her portfolio to stocks, 10% in real estate investment trusts (REITs), 15% in bonds, and 5% in cash or money market funds. Now, this recommendation is in the context of the US. Malkiel recommends that half of the amount in equities should be placed in the US with a substantial portion in small companies and the other half in international stock markets with a considerable portion in emerging economies.
An investor in her late sixties could place 40% in equities, 15% in REITs, 35% in bonds and 10% in cash. Again, emerging markets and US small companies should be well represented in the proportion of equities held.
Here, there are two important points to note.
One, risk and reward are correlated. Malkiel has consistently stressed that small companies grow a lot faster than big companies and in an extension of that principle, sufficient exposure to emerging economies is essential for investors in the developed countries as these countries are unlikely to record high gross domestic product growth rates. Higher growth rates in small companies and emerging companies come hand in hand with higher returns over the long term.
Two, there has been increasing research that substantial exposure to equities remains important throughout the entire life cycle. In a 2005 study by Nobel Laureate Robert Shiller, he concluded that following a “100-minus” portfolio allocation provided an internal rate of return lower than 3%. Lowering exposure to equities as investors age was not an optimal strategy.
In Malkiel’s first lifecycle investing guide published in 1990, his recommendations on equity/bond allocations were broadly in line with the “100-minus” rule. In his latest 2016 edition, Malkiel has since revised upwards the proportion of portfolio held in equities for investors even in their late sixties to a combined 55% (equities & REITs).
The conclusion is, if we want our investment portfolios to provide adequate protection for retirement, we need to stay heavily weighted in equities for much longer than the conventional “100-minus” rule would suggest. Still, such a strategy is especially risky for people nearing retirement and do not have years of future earnings to buffer losses. To that end, following a more aggressive approach by Malkiel and starting to invest early would be the best we can do to prepare for our retirement.
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