Asset allocation is a technique that helps investors distribute their portfolios into several asset classes. By doing so, it can mitigate any risks associated with a market. There are several approaches to asset allocation that investors can use. In essence, however, it involves establishing an asset mix and distributing investments accordingly.
However, establishing an asset mix may not be as simple. Usually, investors need to contemplate what split will maximize their returns while also minimizing their risks. This split will depend on investors’ risk tolerance levels, time horizons, etc. However, investors can also use some rules of thumb that may help them establish an optimal portfolio mix. One such rule is the 120 minus your age rule.
What is the 120 Minus Your Age Rule?
Historically, investors have preferred the 100 minus your age rule when establishing a portfolio mix in asset allocation. Using this rule, investors subtracted their age from 100. The residual amount represented the percentage of stocks that investors must include in their portfolio mix. The remainder amount was the percentage they should invest in bonds and other securities.
However, the 100 minus your age rule was not as effective in diversifying a portfolio. On top of that, it took a conservative approach towards investing. Therefore, investors can use the 120 minus your age rule to get better results. This rule is also similar to the 100 minus your age rule. However, instead of subtracting an investor’s age from 100, they deduct it from 120.
How does the 120 Minus Your Age Rule work?
The 120 minus your age rule works similarly to the 100 minus your age rule. With this approach, investors subtract their age from the number 120. The residual amount represents the percentage of their portfolio that must include investment in stocks. The remaining portion will consist of bonds or other securities. This rule can be significantly helpful in asset allocation.
For example, an investor aged 25 wants to establish the percentage of their portfolio that must constitute stocks. Using the 100 minus your age rule, the investor must include 75% (100 – 25) stocks in their portfolio. However, with the 120 minus your age rule, their portfolio must consist of at least 95% (120 – 25) of stocks. Using this rule, they can take more risks and drive their bar up by 20%.
Does the 120 Minus Your Age Rule work?
The 120 minus your age rule is a rule of thumb or, simply, a heuristic. It can be helpful for confused investors who want to establish a portfolio mix. However, it is not a scientific or proved approach towards success. It only serves to provide investors with a base using which they can develop their own optimal mix.
The effectiveness of such rules also depends on other factors. For example, while investors can use it to establish their portfolio mix, their success will come from the stocks they choose. For example, an investor includes 90% of stocks in their portfolio. However, if they invest in relatively low-risk stocks, their rewards will be lower.
Asset allocation can be a great tool for establishing a diversified portfolio. However, it may be difficult for investors to determine an optimal portfolio mix. Using the 120 minus your age rule, they can establish the percentage of stocks they must include in their portfolio. While it can be significantly helpful, its success depends on how investors use it.