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What's the Right Asset Allocation For Young Investors?

A reader asks:

I have a 36-year-old friend whose IRA—her only retirement savings—has about a 5% allocation to bonds, and a 95% allocation to equities. I've suggested that at her age, it's time to double her bond allocation to 10%. Her husband (29 years old) disagrees, saying she has a long-enough horizon to stay nearly fully invested in stocks.

First of all, I can't really provide specific investing advice because that's not the purpose of this site. But even if I could there's no right or wrong answer here because this type of thing is really about the psychological make-up of the investor in question, not just their age.

Here are a few thoughts on managing money as a young person with multiple decades ahead of you to invest:

Probably the best course of action you can take with years and years of future savings to put to work is to dollar cost average into the markets over time. It's not a perfect strategy but if put on auto-pilot with automated contributions it's likely to be one of the best investing decisions you'll ever make.

Personal finances will matter more than your portfolio, especially when you're young. Create good personal finance habits and you can be set for life.

When you're young you have the assets (human capital) and time horizon to potentially accept huge amounts of volatility in your long-term investment accounts. This is a blessing and a curse depending on your experience with the markets and how you approach investing.

Every investor needs a basic understanding of financial history so they can realize how manic the markets can be at times. History is littered with examples of the madness of crowds. Don't try your hand at investing without the realization that there have always been cycles that eventually reach a point of too much optimism or pessimism. Whatever asset allocation you chose, you have to remember that rebalancing back to your original target weights will almost always mean going against the crowd.

Stock markets around the globe lost nearly 60% of their value in the latest financial crisis. Could you handle seeing your hard earned savings cut in half or worse with a stock-heavy portfolio? Would you have the discipline to stay invested and keep buying all the way down?

Investing is a constant tug of war between feeling safe now and feeling safe later. If you want safety now you're going to have to accept low returns and if you want safety later you're going to have to accept occasional losses. That's the trade-off.

Live within your means. Avoid lifestyle creep. Stay out of credit card debt. Save at least a double digit percentage of your income. Increase the amount you save each year. Keep your investment costs low. Diversify. This is simple advice. But even the best advice doesn't matter if you can't follow it. Humans just aren't designed to deal with risks that are far out into the future. Take this into account when creating your plan.

Avoiding huge mistakes at the wrong times is half the battle. Try to learn from the mistakes of the previous generations who have come before you. Everyone has someone in their extended family that has made huge mistakes with their money.

Once you have a plan in place and have most of your good decisions automated, benign neglect should be the hallmark of your strategy going forward. Allow compound interest to do its thing and try not to get in the way.

The majority of the advice you read these days tells millennials that they're far too risk averse and need to be taking more risk with their portfolios. This is true in a general sense, especially with retirement assets, but we always have to remember that good advice and human nature are often in conflict with one another.

A portfolio comprised of 100%, 95% or 90% in stocks for a young person should make sense, but in reality only makes sense for those who know what they're getting themselves into.

Whether you had 5% or 10% of your portfolio in bonds during the great financial crisis wouldn't have made a huge difference one way or another in terms of losses. That's still a stock-heavy portfolio regardless of 5% here or there.

What really matters is how prepared you are to deal with losses as an investor. One of my favorite quotes (which I've used here before) by Fred Schwed in his book Where Are The Customers' Yachts? sums this up nicely:

Like all of life's rich emotional experiences, the full flavor of losing important money cannot be conveyed by literature. You cannot convey to an inexperienced girl what it is truly like to be a wife and mother. There are certain things that cannot be adequately explained to a virgin by words or pictures.

I've spent years studying asset allocation strategies and my takeaway is that there are many solid allocation choices investors could make and still be successful. The biggest obstacle is not the allocation itself, but forcing yourself to stick with the one that you choose.

 

 
 
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