A Sham for the Ages

Take your age, subtract it from 100. Got your answer? Good. Because according to many investing pundits, that's the percent you should allocate to stocks in your portfolio. The rest should be in bonds, cash, or under your mattress.

But should something as important as your investment allocation be determined by age alone? If only investing were so simple.

For many long-term investors, a strictly age-based approach is wonky at best and can even result in allocations counterproductive to reaching longer-term goals. Yet the idea is consistent with the notion shunning stocks in favor of "safer" investments as one gets older and/or approaches retirement is universally correct—a notion many investors and, disturbingly, industry professionals readily champion. Simply: This cookie cutter solution is a sham.

Some industry traditionalists perpetuate this sham by promoting investment products based on the age-based notion, namely target-date mutual funds. These funds automatically shift further away from stocks as a chosen target date approaches (usually one's planned retirement date). If you don't have the inclination or time to worry about your investment allocation, these set-it-and-forget-it funds probably sound groovy.

But there's a problem—you do need to worry about your investment allocation.

You may not know this, but target-date funds aren't held to some universal allocation standard that perfectly adjusts to your situation. The allocation decision is left to the fund manager, who knows nothing of you, your specific situation, or your goals and is simply pigeon-holing you with others who arbitrarily picked that same date.

Furthermore, fund managers clearly don't agree on optimal allocations for specific target dates. For example, take someone who's 59 planning to retire at 65—they might pick a 2015 target-date fund. Morningstar's fund screener reveals myriad offerings, but the investment allocations vary—sometimes drastically—from fund to fund. While stock allocations typically range from 40% to around 65%, one 2015 fund had 0% in stocks—yes, zero percent—and another had a 38% cash allocation! Wide variations also exist in foreign versus domestic stock allocations and sector/style allocations.

With such allocation discrepancies among funds with the same target date, how does an investor pick the right one? After all, investors choose these funds so they won't have to worry about allocation decisions.

But it seems they'd do well to worry. Say our hypothetical would-be retiree owned a 2015 target-date fund through the most recent downturn. The three largest 2015 target funds (according to Morningstar's website) dropped an average of roughly 41% from peak to the March low. These so-called "safer" investments were still clocked. To boot, they'll likely cheat investors out of precious upside during the recovery given their "safer" allocations of 50% bonds, 38% cash, or who knows what! (Case in point: To date, those three funds are significantly lagging the S&P 500 from March 9th lows.) Full participation in the initial stages of a new bull market can be essential to those who need long-term, stock-like returns to meet their objectives—especially a pre-retiree with high income and growth objectives. Such an age-based allocation by definition prevents full upside participation.

Factors like your financial situation, investment horizon, projected cash flows, and longer-term growth objectives are most important when determining an appropriate allocation—not age. You're retiring at 65? Great! Should your allocation automatically change then? Maybe. Maybe not. But a fund manager running a date-based fund won't ask.

Age just isn't the factor much of the investing world professes it to be. Maybe you rely on your portfolio for income or maybe you want to grow the assets for your family—or maybe a bit of both. Maybe you hate your family and want to spend all your money. Either way, your age has almost nothing to do with that stuff. And if you love your family, you'll want to leave them money, which means your investment horizon extends beyond your life expectancy, further rendering age a less important factor. Also, folks are living longer these days and the age-based approach often drastically underestimates how long investors need their assets working. Someone retiring at 65 could easily live another 30 years and need their investments working hard the entire time to cover costs.

While age-based allocations and target-date funds are popular tools, they clearly ignore many important factors. The age-based approach is a simple concept and comforting to many. But the riskier play is blindly submitting your retirement funds to an allocation based solely on age—a factor that, by itself, has very little to do with your actual investment goals.

The age-based approach may be an easy sell, but I think it's a sham for the ages, and I hope you don't buy it.

Source: Google Finance, Morningstar.com