How should your asset allocation change over time?

Any financial planner will tell you that asset allocation—the mix of stocks and bonds in your portfolio—is one of the most important decisions an investor can make. Your asset mix should be appropriate to your goals and your tolerance for risk. But what if those factors change over time?

The conventional wisdom suggests you should make your portfolio more conservative as you get older, lowering your allocation to riskier stocks and replacing them with safer bonds. You’ve probably heard the rule of thumb that says your allocation to bonds should roughly equal your age—for example, a 30-year-old might hold 30% of her portfolio in bonds, while a 60-year-old would double that to 60%.

This is the key idea behind target date funds, an increasingly popular option in employer-sponsored plans, such as defined contribution pensions and group RRSPs. Target date funds get gradually more conservative as you approach your retirement date. If you plan to retire in two decades, for example, you might choose a fund with a target date of 2035. This fund might hold 70% or 75% equities today, but that allocation will decline over the years and by 2035 the fund will be primarily in bonds and cash. This transition is called the fund’s “glide path.”

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Target date funds are often criticized for being cookie-cutter solutions that ignore individual circumstances. Graham Westmacott, my colleague at PWL Capital, has done some compelling research that suggests the whole notion of moving from an aggressive portfolio to a more conservative one is flawed: in his analysis, even “the best possible glide path strategy offers virtually no improvement” over a simple balanced fund that maintains a constant asset allocation. In the paper, Westmacott introduces a more dynamic strategy that’s tailored to each individual, rather than following a generic glide path.

Which path should you follow?

What’s the average investor to make of this? We understand there is probably an optimal way to adjust our asset allocation over time, but we recognize it’s impractical—maybe impossible—to manage our portfolios that way. Most of us just want a simple solution we can put into practice. So here are a few suggestions to help you do the best you can.

First, recognize you will need to make some course corrections over time. I’m a big fan of simple solutions, but you can take that too far. The idea of a “set it and forget it” investment strategy is appealing, and it can work well for a while. Eventually, however, you need to switch off the autopilot and make some changes to the flight plan. And sooner or later you need to land the plane manually.

Chances are your path to retirement is going to include any number of unexpected twists: a career change, a big promotion, a layoff, a home purchase, a divorce, lean years while raising kids, an inheritance. Your savings plan—and your portfolio’s asset mix—will need to change when these events occur. Whenever your life or financial situation changes significantly, it can help to review your plan with a professional.

Next, don’t get paralyzed by the search for the perfect asset allocation, or the ideal plan for changing it over time. Every year tens of thousands of Canadians reach their retirement goals successfully, and exactly none of them followed an optimal path to get there.

What if you’re just starting out?

If you’re just starting your career and you have an opportunity to enroll in a pension plan or group RRSP, take full advantage. Save as much of your paycheque as you can manage and make sure you collect any matching contribution your employer offers. If your group plan offers a menu of fund options, a target date fund or a traditional balanced fund are good default choices.

Remember why target date funds were created in the first place: because many investors with group plans have no clue how to build a diversified portfolio with an appropriate level of risk. Westmacott and his coauthors cite a report from Sun Life that found 24% of participants in group retirement plans held either 100% equities, or no equities at all. Those extreme positions could have been arrived at thoughtfully, but I doubt they were. Almost all of those investors would likely be better suited to a target date fund or a plain old balanced fund, even if those solutions aren’t optimal.

I love the story of Harry Markowitz, the Nobel laureate who pioneered the idea of portfolio diversification in the 1950s. If anyone could design an optional plan for asset allocation, it would be Markowitz. But what did he do with his own money? “I should have computed the historical covariances of the asset classes and drawn an efficient frontier,” he explained. “But I visualized my grief if the stock market went way up and I wasn’t in it—or if it went way down and I was completely in it. So I split my contributions 50/50 between stocks and bonds.”

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