The Right Portfolio For You
When it comes to investments, age isn’t just a number. Imagine being 25 with a higher-than-average salary for your industry. You aren’t married, don’t have significant debt or mortgage commitments, and have plenty of disposable income. Now, imagine being 30 and married with kids and the obligation of a mortgage but with an equal or even higher salary.
In both situations, you want to invest your capital responsibly and gain from your investments. But here’s what’s different between the two ages: your investment goals – both in terms of your liquidity needs and the amount of portfolio volatility you’re comfortable with. In other words, your risk tolerance changes with age and so should your investment strategy.
Understanding your investment goals is the key to making sure you have a healthy investment portfolio and desired returns. In this article, we will explore how age influences portfolio asset allocation and how you can have a portfolio that works for you at every age.
What Is Risk Tolerance?
Risk usually means one of two things: liquidity risk and volatility.
Liquidity is how quickly you can buy and sell an asset without affecting its value.
A highly liquid asset would be something like cash—you could get its worth at any time with no real loss of value. An illiquid asset is the opposite: it takes more time to convert to cash. But investments are not static, so a previously liquid asset could become illiquid and vice versa.
Volatility refers to how much an asset fluctuates in value.
Volatility contributes to drawdown risk, which is a peak-to-valley decline during a specific period for an investment, fund, or trading account. Some asset classes, such as equities, are inherently more volatile than others, like bonds. Typically, more volatility usually comes with higher returns.
Your ability to tolerate these changes determines how much risk you are willing to take on.
Risk tolerance, at its core, boils down to how much risk you're willing to take on to achieve a certain level of return.
How Does Age Influence Risk Tolerance?
While a more risk-averse individual will always make safer decisions than someone less risk-averse, risk tolerance depends on a lot of factors including age, life stage, the number of incomes contributing to a household, the number of dependents, etc. When it comes to investment advice, age is often a proxy for liquidity needs and volatility considerations. This is why traditional investment advice prescribes an age-based asset allocation.
An investor's risk tolerance is reflected in their need for liquidity. For example, if your goal is to buy a house or pay for college tuition in the next five years, you will need liquid investments. On the other hand, if you’re willing to sit on investments for 30 or 40 years and cash out only in retirement, you can afford to invest in illiquid assets.
No matter what your age is, to figure out your liquidity needs, you should ask yourself, “Will I need to cash out my investments anytime soon for a big financial commitment?” If yes, you will want to have a highly liquid investment portfolio.
Appetite For Volatility
Investors who do not have a lot of liquidity concerns are typically also willing to stomach more volatility. For example, if you want to buy a house for which you’ll need to cash out your investments, you may not want to have a highly volatile portfolio because you may be forced to sell your assets at a time when the market is down. Consequently, you won’t gain much from your investments (and you may even experience a loss of starting capital).
If you want higher returns from your investments, you should be willing to have a more volatile portfolio. Traditionally, this may mean having a larger asset allocation to more volatile asset classes.
Starting Portfolio Size
Your portfolio size significantly impacts the risk you can safely take. Each investor’s natural risk tolerance is different and unique to them. Regardless of age, the larger your portfolio (or the more capital you have), the more risk you can afford to take.
Think of it this way: an investor with $10,000 and an investor with $100,000 invest $2,000 into Company A’s stock. Company A fails, and the stock value drops significantly. Investor 1 has lost 20% of his initial investment pool, while investor 2 has only lost 2%. Though the investment was equally volatile for both, it was significantly riskier for investor 1.
Here’s the bottom line: investment decisions largely depend on risk tolerance, which has a complex relationship with age. While people in similar age groups can experience similar circumstances and have life goals (like buying a home or saving for retirement), a one-size fits all approach that’s traditionally recommended to most retail investors is not the way to go simply because liquidity needs and volatility concerns may be vastly different for people within the same age bracket.
If you’re single with no financial obligations, you don’t need as much liquidity even at 30. But a 30-year-old with a family and mortgage thinks about liquidity differently.
The Traditional Investment Advice AKA "One-Size-Fits-All" advice that pairs age range with risk tolerance recommends that individuals invest in a proportion of stocks equal to 100 (sometimes 110) minus their age, with the rest comprising lower risk asset classes like government bonds.
This advice is based on the natural decrease in risk tolerance faced by aging investors. Stocks are more volatile than bonds but also offer higher returns. So according to the traditional method, a younger individual is not supposed to stay as “safe” as an older one. In other words, younger people, typically those in their 20s and early 30s, can afford to allocate more to inherently volatile asset classes like stocks.
This traditional advice often fails to consider how individual circumstances vary vastly for people in the same age range. It takes age as a proxy for risk tolerance.
Ultimately, this approach results in an inadequately diversified stock-bond portfolio that’s not suited for individuals and changing liquidity/volatility needs. What if you need to buy a house and start a family at 28? Because you followed the typical 100-age asset allocation formula, you would have a super volatile portfolio that would not help you realize your financial goals.
Retail investors should not consider this traditional asset allocation advice to be optimal. Instead, start looking at asset allocation models which advocate diversification and adjust according to your individual liquidity needs and volatility appetite rather than just your age.
The Hedgeful Asset Allocation Model: Diversify and Lever Your Portfolio
Asset allocation at any given age depends on volatility appetite and liquidity needs. Younger investors can typically take on more risk and have lower liquidity needs. But instead of holding a stock-heavy portfolio when you’re young and a bond-heavy one as you age, you should consider two powerful tools to adjust your portfolio’s volatility: leverage and diversification.
Adjusting Asset Class Volatility Using Leverage
As mentioned earlier, each asset class is packaged to have inherent volatility (e.g., stocks are more volatile than bonds). But using leverage, this volatility can be adjusted. With leverage, you don’t have to keep asset classes at their pre-packaged volatility levels.
Bonds can be leveraged to offer stock-like volatility, while stocks can be de-levered to bring their volatility down to level of bonds. But how do such adjustments benefit an investor? By allowing them to diversify regardless of age/volatility appetite.
Suppose you determine that you want 5% portfolio volatility. You could go the traditional route and build a stock-bond portfolio such that the overall volatility remains 5%. But such a portfolio is vulnerable to sudden market shifts which could cause a decline in the value of stocks or bonds or both. This would mean you end up with a risky portfolio with an uncertain return profile.
Now if you could have a diversified portfolio with a balanced asset allocation to both stocks and bonds but with the assets levered/de-levered to keep the volatility at 5%, you would still have your investment goals met and be protected from market shocks. Leverage modifies the amount of volatility an asset class has by a variety of methods like investing more/less capital in it or using futures. By modifying an investment strategy using leverage, low-risk, low-return assets can be converted to high-risk, high-return assets.
Using leverage to adjust asset volatility, therefore, helps you build a diverse and reliable investment portfolio more suited to your investment goals at any age. For younger people with little financial obligations, such a portfolio would have higher volatility but still be diverse. For older or those with a lot of financial commitments, it would be both diverse and less volatile. With leverage, diversification doesn’t come with lower returns.
Diversification across asset classes and markets helps you build an investment portfolio that remains protected from sudden market shocks in a particular geography or timeframe. Typically, diversification means holding a mix of negatively or lowly correlated asset classes beyond just stocks and bonds. Even within stocks and bonds, investors of all ages should seek to diversify using indices instead of individual stocks and bonds.
Alternative asset classes such as commodities, gold, real estate, inflation bonds, and crypto offer excellent diversification. Moreover, emerging market stocks, bonds, and foreign developed assets can help with geographical diversification.
Multi-asset funds can provide investors with greater flexibility, providing exposure to a broader range of assets. This protects investors from the risks of decoupling and market failures while helping them reach their liquidity goals.
Hedgeful’s asset allocation model ensures you meet your individual investment goals without exposing yourself to more risk or bearing lower returns. In short, it doesn’t take your age as a proxy and instead looks at your liquidity and volatility concerns, as well as your long-term investment goals.
The one-size-fits-all approach that has been advocated for decades puts too much emphasis on age without considering how it affects investment goals for individuals. Taking such advice can only result in less-than-adequate returns, vulnerability to market shocks, or an inability to use your capital when you need to. Instead, a balanced, tailored approach to investments where your liquidity and volatility concerns matter more than how old you are is the way to go.