Reduce the risk levels of your investment portfolio as you grow older in order to increase financial certainty. The closer you get to retirement, the more important it becomes to increase your financial certainty by locking in your investment gains. Shifting your money into more conservative investments helps to lock in gains. With fewer working years left, your ability to recover from losses is reduced and your need for certainty increases.
Consider lifecycle funds, which re-allocate your assets over time for you. A type of mutual fund called the lifecycle fund takes care of changing the allocation of your investments as you grow older. This leaves you more time to practice your golf swing.
Like a fine wine, an investment portfolio should mellow as it ages. A 35 year old’s portfolio is like a young wine, bright and tart with calculated risk, substantially weighted toward stocks and their higher potential for long term gain. A 60 year old’s portfolio should be smoother and gentler on the stomach with moderated risk.
Earlier in life, you have plenty of time to deal with investment risk. Your investments should be mostly in assets that have the potential for growth. Then, as you get older, the mix of investments should gradually shift toward assets with more stable values. This helps to lock in gains and ensure that money is available for your golden years.
Working years are the time to accumulate assets, and to make them grow. Earned income should be converted into stocks, real estate and other investments with the potential for appreciation. However, when the golden years approach, people will need cash from their investment portfolio to cover living expenses. You can’t buy a bottle of champagne with a share of stock. Older investors should gradually shift more of their investments to stable assets like cash, bonds, bank and credit union CDs, and money market funds.
How Does One Diversify Over Time?
As we have discussed, there is no formula for diversification that is absolutely ideal, because no one can predict the future with certainty. A reasonable and simple formula for someone who is around 45 years old might be to invest 70% of his or her portfolio in stocks and 30% in bonds.
As this investor grows older, it would be advisable to reduce the stock portion of the portfolio, such as to 60 % by his or her mid-50’s. The 10% taken out of stocks should be invested in bonds or bank CD’s. In the investor's 60’s, the stock portion should be further reduced to around 50%, with the additional 10% taken out of stocks again invested in bonds or CD’s. By his or her mid-70’s, the stock portion should drop even farther, perhaps 30% to 40%, while most of the portfolio would be in bonds, bank CD’s and money market funds.
This gradual change in the asset mix toward stable investments reduces the risk of loss, and provides the investor with greater certainty. Cash from one's portfolio becomes important in retirement because the investor no longer has earnings to cover living expenses. Moreover, as you get older, your need for long term gains diminishes, since your remaining lifespan is getting shorter. So you have less need to take the risks of stocks.
A shift to relatively stable investments, like bonds and CD’s, offers less long term protection against inflation than stocks (although note that stocks don’t provide short term protection against inflation, either, as interest rate increases made by the Federal Reserve Board to quell inflation can knock stocks right out of their socks). However, as you grow older and your remaining lifespan diminishes, inflation protection becomes less of a priority, and the certainty of cash for your living expenses becomes more important.
If you are a do-it-yourself investor with mutual funds, stocks, bonds, etc., you will have to alter your asset mix yourself over the course of your life. In our discussion of model investment plans, we give you suggestions for allocations of investment assets at various ages. Or else you can automate the process with the type of mutual fund called life cycle funds.
Imagine an investment where you pay in your money, and then have someone else do the work of choosing a diversified portfolio and changing the portfolio’s asset allocation as you grow older. Such an investment could save you a lot of effort, especially if you’re not a financial expert. That’s the idea behind a life cycle fund.
A life cycle fund tries to give you the asset diversification that is appropriate for your age, with a gradual shift to more stable investments over time. In your 20’s or 30’s, the life cycle fund will be heavily weighted toward stocks, with their long term potential for growth. Since you are still young and can expect to work for many more years, you have greater capability to recover from cyclical downswings and other financial setbacks, and thus can capture the long term gains offered by stocks.
As you get older, the life cycle fund gradually shifts its asset mix toward conservative investments, in order to increase the stability of your investments and gradually lock in your investment gains. As we noted above, the shift toward a more conservative asset mix also means you have less potential for gain. But that is inherent in achieving greater stability in value.
The simplicity of the life cycle fund, from the investor’s standpoint, can save you a lot of work. Of course, you to make sure that you are comfortable with the way the life cycle fund operates. They are offered by a number of mutual fund families, and different lifecycle funds have different asset mixes and investment philosophies. Some are more aggressive and will take bigger risks than others, believing that increased life expectancies mean that retirees should plan for a long retirement. They also carry increased risk of unexpected downswings in value. Other life cycle funds are more focused at maintaining stability; but they may not provide as much money in your later years. As we have said before, there is no absolutely ideal formula for asset allocation because no one can predict the future with certainty. The most you can do is be aware of what’s happening with your money and make sure it’s something you’re comfortable with.
Now that we’ve given you a fair amount of investment theory, let’s go now to our discussion of practical guidelines for investment.