By Vinay Ahuja, Executive Director, IIFL Wealth
Traditionally, age has played an important role in equity allocation. The widely followed thumb rule ‘100-age’ dictates the percentage of allocation made to equities. As per this thumb rule, your equity allocation is calculated by subtracting your age from the number 100. For example, if you are 30 years old, then, as per this thumb rule, your equity allocation will be 70 per cent (100-30). The main assumption here is that as you grow older, your willingness and ability to absorb risk reduces. Correspondingly, so should reduce your equity exposure. However, this assumption is flawed. Age simply cannot be the sole determinant of your equity allocation.
Take for example, two individuals Ram and Shyam, who are both 45 years of age. Now, Ram has a steady high-paying job, a small outstanding home loan, and minimal liabilities. He is not married. Shyam, on the other hand, is married with two children, aged 15 years and 12 years. He has a steady high-paying job but also has an outstanding home loan and a car loan. As per the ‘100-age’ rule, both Ram and Shyam should allocate 55 per cent of their portfolio to equities. However, that does not sound right, does it? Since Shyam has more liabilities and a family to take care of, his ability and willingness to absorb risk would be lower than that of Ram. Thus, a 55 per cent allocation for Shyam might be too high. On the other hand, since Ram has minimal liabilities, a 55 per cent allocation to equities might be too low.
The Oracle of Omaha had something interesting to say about this. In a 2013 letter to Berkshire Hathaway shareholders, Warren Buffett shared an investment plan for his wife which was in contradiction to not only the ‘100-age’ rule but also contrary to what is advised to most retirees. He wrote that after his passing, the trustee of his wife's inheritance has been directed to invest 90 per cent of her money into a stock index fund and 10 per cent into short-term government bonds. While most investors are advised to reduce equity exposure as they age, the most astute investor of all was advising the opposite. The most important thing to understand is that clearly, there are several other factors at play when it comes to equity allocation. Two primary ones include:
As an individual investor you have a unique risk profile that captures your willingness and ability to take risk. In this case, willingness alludes to how comfortable you are with taking risks and is more of a psychological factor. Ability to take risk, on the other hand, can easily be measured. It takes into consideration your current and expected future income, your current and expected future liabilities, and your assets. Somebody who has a large investment or asset base and limited liabilities would definitely be better positioned to withstand risk compared to somebody who has few investments and higher liabilities.
Investment time horizon
It is well-known that equities are long-term vehicles of wealth creation. Thus, if as an investor, you have a lot of goals coming up in the next 2 to 5 years, then a large allocation to equities might not be appropriate, irrespective of of your age and risk profile. On the other hand, if a majority of your goals are long-term in nature and will start coming up after a period of 5 to 7 years, then a larger allocation to equities might be warranted. However, this should be in line with your overall risk profile.
Age has two aspects to it. One is your chronological age and the other is your biological age. You should not let your chronological age dictate how you live your life. Similarly, you should not let it dictate how much you invest in equities either.