Should your Age Determine your Equity Allocation?

If you are investing in mutual funds, you might have heard people talk about portfolio allocation. It is often advised to keep your equity allocation at 100 minus your age. Is this sound advice and something that you should follow to a T?

It is generally understood that younger people have a higher capacity to take risk. As you age, your capacity to bear risk comes down. Why is this so? When you are young, you have lower commitments and also longer time for big goals in life – say your child’s education or your retirement. That means, you can take risks, even get hurt a bit and yet be on your way to build wealth. Hence, prima facie, it sounds like good advice to have higher allocation to equity (which is seen as a risky asset class given its volatility)  when you are younger and reduce your equity allocation as you age. But is that an all-season rule that can be followed at all times? Not necessarily. But before we explain why, let’s first understand your risk capacity really means.

Risk capacity matters, not risk attitude

Your risk profile can be split into two parts: your risk taking capacity and your attitude toward risk. Risk taking capacity is different from the attitude toward risk. If market volatility worries you, that’s your risk attitude (or risk tolerance). If you panic on seeing a big fall in the value of your investments, that’s your risk attitude. This however, does not indicate your risk capacity. Risk capacity indicates how much risk you could have taken based on your financial health, if you were completely neutral in your attitude to that risk.

Consider the example of a 32-year old IT professional. He started working when the sector was experiencing a boom and is earning a good salary today. He also has decent amount of savings in his bank. This person’s parents had a poor experience with the stock market. As a result, it was inculcated into him that stock markets are akin to gambling and he would do better to keep his money out of stocks. Today he looks at the rise and fall of the Sensex and takes comfort in having put all his money only in bank deposits. This person would be classified as conservative or risk averse. But does that mean this person cannot take any risk at all?

From a purely financial planning perspective, taking some risk will give his investments greater wealth building potential. Any short term fluctuations in the value of his investment would not really matter to him as he would be comfortably placed due to his savings in banks. This indicates that the person has a high risk capacity.

Thus, while risk attitude tells you how you feel about risk, risk capacity tells you how much risk you can actually afford to take.

Relationship between age and risk profile

Let us now look at the relation between age and risk profile in the light of the above discussion.

1. Your attitude toward risk may or may not change with age. It has less to do with your age and more to do with your experience with risky investment products and understanding of such products.

2. Your risk capacity goes down with age because you have lesser time to reach your financial goals. If you have, say,  3 more years to save up for your daughter’s education you have far lower risk capacity than another person with 10 years to go. This is because when you are not far from your goal, you need to invest high sums, save more to reach the goal. This exposes your money to greater short-term risk. Hence, you cannot afford to expose large amounts to huge risk. On the other hand, a person with enough years to go for the goal, can save smaller amounts, expose himself to risk in a more gradual manner and actually make the best of such risk by averaging in ups and downs.

3. Your risk capacity is low when it comes to goals that are a priority as opposed to goals that can be postponed. For example, if you are saving up to pay the school fee for your kid for next year, it is a non-negotiable goal. You cannot afford too much risk there given the time frame and the nature of the goal. If you are saving up to buy an iPhone in 6 months, it is possibly a negotiable goal that can be postponed to even next year. Here, your risk capacity is marginally higher.

4. Your risk capacity may also go up with age because you have a cushion of existing investments to fall back on and fewer financial goals to meet. For example, you may feel more confident investing more in equity in your 40s if you had a large surplus tucked in by then.

5. If you wish to generate regular income, from day one, from your investments, your risk capacity is significantly diminished, irrespective of how old you are. This is because you cannot expose your corpus (the base capital) that you invested to risk of erosion as it needs to generate a fixed amount of cash flow for you.

How far is your goal

The point you should focus on is the time to reach your financial goals and the nature of your financial goals (negotiable or not, or cash flow requirement or not). When you decide on your equity allocation, your age has only so much role to play. What matters more is the time that is left for a particular goal. And for this, it is essential to plan your finances separately for each individual goal. When you do that you will need to know why you cannot use equity for very short-term goals or how much equity to use for medium to long-term goals. For this purpose, it is good to know the risk equity carries over different time frames.

The following table shows the proportion of times equity funds delivered losses for different holding periods in the past ten years. The way this has been calculated is to take returns of each period mentioned in the table every single day since December 2007.

As you can see, the proportion of negative returns comes down in all categories as the holding period becomes longer. Also, over the past 10 years, funds have never given negative returns over a 7-year time frame. This number gets diminished when one used SIP.

So how does age really relate to your equity allocation and how should it affect your equity allocation? Truth is, there is no one-size-fits-all answer to this question. Equity allocation should reduce as you age, but rather than looking at it as a function of your age, you should look at it as a function of the time remaining for the goal.

You should review your portfolio every year and at the time of this review, you should also assess your risk profile. Do you feel more comfortable taking risks today than you did a year ago? Has there been a significant change in your financial health since the last year (addition or reduction of dependent members, fulfillment of a major goal, significant reduction in existing investments, etc.) which affects your capacity to take risks? Now combine these with the time remaining for your individual goals. Review the equity allocation in the light of this knowledge. You are likely to construct a much better portfolio with this approach rather than deciding your equity allocation purely based on your age.