Life
Stages Planning – The Big Con
What’s
Wrong With Age-Based Asset Allocation
How
old are you?
Who
knows that? Your family, maybe some friends and some people at work.
That’s it. Nobody else knows. Do you think anybody at the
New York Stock Exchange knows how old you are? How about the people
at the US Treasury? Do you think they know how old you are?
Then
why would anybody base their asset allocation decisions on their
age? Because Wall Street says so?
The
marketing departments at many mutual fund companies, 401(k)s, insurance
companies and brokerage firms have spent millions on beautiful marketing
materials and brochures that extol the virtues of Age-Based asset
allocation (Usually called Life Stages Planning or something similar.).
The logic is simple, the younger you are, the more stocks you should
have, the older you are, the more bonds you should have. Here’s
an example of the suggested allocations:
|
Age
25 |
Age
45 |
Age
64 |
Stocks |
75% |
55% |
20% |
Bonds |
20% |
40% |
75% |
Cash |
5% |
5% |
5% |
The
logic goes like this: The younger you are, the more you can be in
stocks because you have more time to make up any potential losses
suffered from a market decline. The older you are, the more you
need income and need to preserve your assets, so you need bonds.
The
problem with this is that it completely ignores market cycles. Shouldn’t
an overvalued market reduce your stock market exposure, regardless
of your age? Shouldn’t rising interest rates reduce your bond
exposure? The answer to both questions is obvious – Yes.
The
market does not know or care how old you are. There are 25 year
olds investing for the first time every single day. Does that mean
every day the market is a good buy? There are 65 year olds retiring
every day. Does that mean they should be buying bonds, regardless
of the direction of interest rates?
Market
cycles are as predictable as the weather. That would normally be
a sarcastic remark, but here’s what I mean. Day to day, no
one can predict the stock market or the weather with 100% certainty.
Luckily, for a successful investment plan, you don’t have
to.
But
the bigger cycles are very predictable. Winter follows Summer. Bears
follow bulls. It has always been that way. Every year you get ready
for winter - pull out the winter jackets, find the snow shovels,
get sand or rock salt for the sidewalks. Why? Do you know ahead
of time which days will be cold or snowy? Of course not, but you
know the characteristics of winter will be snow and cold. So you
prepare for it.
But
the stock market cycles are much longer than most expect. They are
measured in decades, not months or years. So people are not used
to seeing the signals that a bear is approaching as easily as they
see the signs of winter. But if you look carefully, they are just
as clear. Do you need to know which days will be the worst? Of course
 not.
Just knowing the characteristics of a bear market will change your
asset allocation.
During
the 20th Century, there were 3 major bull markets. The first ended
in 1929. The next ended in 1966 and the last ended in the 1st quarter
of 2000.
The
bond market has had similarly long cycles. Bonds were in a 40+ year
bear market that didn’t end until about 1982. It worsened
in the last 10 years as inflation heated up during the 70’s.
They’ve been in a bull market ever since rates peaked. The
recent bottoming of rates may be signaling that the bull market
in bonds is over.
So
lets suppose there was a certain 25 year old that wanted to follow
Wall
Street’s asset allocation advice. But instead of 2005, its
1966. His experience in the market would not be a pleasant one.
From the peak in 1966, it took 16 years for the market to finally
break-even and get above the ’66 highs. Our 25 year old is
now 41 and has been running in place for the past decade and a half.
I’ll bet he’s glad he put 75% of his assets in stocks!
(By the way, he also had to endure 5 bear markets in a row, the
worst of which was a 50% decline. How many investors would stay
in the market for 16 years if this was going to be their experience?)
And
how about the guy that worked all of his life and now is ready to
retire? Wall Street says he should put most of his assets into bonds.
Good idea if interest rates are declining. But what if this is 1975?
Interest rates went straight up for the next 7 years. Which means
his bond portfolio lost money the whole time. To add insult to injury,
had he waited to invest in bonds, to when the cycle was appropriate,
he would have doubled his income as rates went from 8% to 16% from
1975 to 1982.
The
point is this – market cycles determine asset allocation,
not the investor’s age. Yes, as one gets older, they may need
more income and want to be more conservative, but to invest without
any regard to the market cycle is dangerous.
So
whenever you see someone recommending some kind of “Life Stages
Planning” or some other nicely packaged age-based asset allocation
- run! You know that person knows nothing about market cycles and
how they should determine asset allocation.
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