Photo of Lars Kroijer hedge fund manager turned passive index investing author

Former hedge fund manager Lars Kroijer now advocates passive index investing as the best approach for most people. You can read more in his book, Investing Demystified.

How you should allocate your portfolio across the main asset classes – shares, bonds, cash?

Like most things in investing (and in life) it depends on your circumstances and your tolerance for risk.

Age is a big factor for nearly everyone, though.

The following diagram shows how your portfolio allocation may shift between equities (shares) and the minimal risk asset (government bonds for UK and US readers) over the course of your lifetime.

Graphic showing typical asset allocation at different ages

(Note: To keep things simple I’m ignoring the complications of riskier foreign government bonds and also of corporate bonds.)

As you can see, most people should start off with a relatively heavy allocation to shares. Over their lifetime this is gradually tapered and replaced with a growing allocation to government bonds.

The rest of this post explains why this is usually a good idea.

How should younger savers invest?

Generally speaking, young savers should allocate a greater portion of their portfolio to riskier assets.

Young people are in the early stages of saving, and the cumulative benefits of even a small outperformance from a riskier allocation can add up to a large amount of extra money over the coming years.

If the markets turn south, young savers have decades before they need the money. They have more time for their investments to recover and make up the shortfall, or for them to adapt their lifestyles or increase their saving rate to fix the problem.

The best time to learn about the markets and how to deal with its risks is when you’re young. Getting into the habit of saving money and sticking with it will serve you very well over your lifetime, particularly as you begin to see the cumulative gains from being a saver due to compound interest.

My advice if you’re young is that you take a risk with your savings and put a lot in the equity markets. Be ready to see it rise and fall in value – perhaps dramatically – and keep enough cash in the bank so that you can afford to ride out a big fall in the stock market (known as a “drawdown” in investing circles).

You should also familiarize yourself with all the tax benefits that might arise from pensions or other savings vehicles, such as ISAs in the UK, in order to ensure you keep as much of the return as possible.

How should you invest in middle age?

Once you’re into your 30s and 40s, you’ve passed into the ranks of the mid-life savers.

You could well be at your prime in terms of earnings power and you’re probably getting a sense for how things are going to turn out for you career-wise, too.

You might also be starting to get a feel for what your expenses in retirement will look like. And maybe how many income-earning years you have left before retiring.

Often you’ll want to allocate a greater fraction of your portfolio to your minimal risk asset, perhaps in longer-term bonds, than you did a couple of decades earlier.

But whilst you could already have accumulated a fair amount of money in your portfolio by this age, in most cases the potential extra return from keeping a continuing allocation to equities will be important to reaching your financial goals in retirement.

Should the equity markets be bad going forward, you still have some working years to address the losses on your investments, either by saving up more and reducing your current spending, planning to work longer, or reducing your expected spending power in retirement.

For many mid-life savers, tax considerations should again play a major role in the execution of their portfolio.

Make sure you’re thinking with a multi-decade time horizon when deciding where to shelter your assets, and keep up-to-date with the latest government legislation.

Asset allocation for retirees

At the other end of the spectrum we have someone already in retirement – perhaps without a huge excess of savings to get them through their remaining years.

This group of savers should have a far lower tolerance for risk. That’s because they have fewer options to make up for a shortfall if the stock market turns against them.

At the risk of over-simplifying, if you are not going to benefit very much from the upside of having more money (with limited years left to enjoy it) because you already have enough – but you would experience the painful downside of having to eat beans on toast in your old age if your investments go down – then don’t gamble with your retirement and stay with minimal risk bonds.

Of course estate planning and passing on assets to the next generation could well play a major role here, in terms of the exact structuring of your portfolio.

Also consider what non-investment income you can expect – company pensions, social security, and so on – and compare that to your expected outgoings.

The difference between the two will need to come from investment income, or by liquidating part of your portfolio for cash or a guaranteed income such as an annuity.

While rules of thumb don’t apply universally, if you retire at the typical age and stick to only spending 4% of your portfolio per year, you will probably be fine. (You can increase that percentage as you grow older – we’re all living finite lives and you can’t take it with you!)

A realistic and slightly morbid point – I would also encourage you to get ready for the day when you can no longer handle your savings yourself, or even plan to pass it on.

Keep things simple in your older years. Have only a couple of accounts and not too many investments, and make clear to whoever is going to take over the management of your assets how you think they should be managed and why.

You can look at Warren Buffett’s estate planning for his wife for inspiration to keep things simple. Buffett’s instructions are merely to divide his wife’s money between a Vanguard equity tracker and short-term US government bonds.

What about if you’re rich and old?

You should note though that Buffett has instructed his executors to keep a far higher proportion of his wife’s assets in equities than would be sensible for most retirees.

We can presume that’s because the sums involved are relatively massive, and thus a fall in the stock market would not be a big threat to his wife’s standard of living!

If you retire with much more money then you need, then the risk profile of your portfolio may be different, too.

Rich retirees are often no longer investing only for their own needs, but also for the longer term needs of their descendants or whoever the assets will be going to, such as a charity or a bequest.

Since the time horizon for those descendants can be much longer term and since their own needs for day-to-day living for the rest of their lives are already covered, their portfolio could well include more equities and a generally riskier profile than if it was just for the retirees themselves.

How to shift from one allocation to another

As for the practical matter of reducing your investment in equities and raising your allocation to lower risk assets as you age, it’s usually best to do this as part of your normal investing activity.

For instance, if you’re regularly saving into a SIPP each month, do some sums and over time start to direct a greater portion of the savings towards your bond holdings.

Investing Demystified book coverSimilarly, if you’re paid income from your share portfolio as a dividend, as you get older you could reinvest that money into bonds rather than buying more shares.

The idea here is to reduce trading costs, and in some case taxes.

Another option is to use a so-called life-styling product that gradually shifts from equities to shares as you age. These are already very popular in the US, but watch out for high charges and hidden fees.

You could use something like Vanguard’s cheap LifeStrategy fund. This automatically splits your assets between global equities, bonds, and other assets, with a fixed allocation to equities.

Monevator has previously discussed how to gradually transition your money across two such funds to create your own simple DIY life-styling strategy.

Lars Kroijer’s Investing Demystified is available from Amazon. Lars is donating all his profits from his book to medical research. Check it out now.

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