You’ve surely heard the standard advice that people should own more bonds than stocks as they age because stocks are riskier and older investors have less time to recover losses. I’ve always thought it was a half-baked idea, and rising interest rates show how costly it can be.
Case in point: The broad US bond market has lost money since rates began to rise in 2021, even after accounting for interest, because bond prices sank when interest rates surged. Meanwhile, stocks have put up some of their biggest gains ever. The unhappy result: Investors who leaned heavily on bonds gave up big profits.
For many following the age-based playbook, it was a needless missed opportunity. Allocation to stocks and bonds doesn’t depend on age, per se; it depends on how much risk investors are able and willing to take on, two considerations that are only tangentially related to age when understood properly.
See more: Remember Why You Buy Bonds
To start, it’s important to be clear about what risk means in this context. Most investors have diversified portfolios that more or less track broad stock and bond markets. They are not seriously in danger of losing money permanently, assuming they hang on, because markets have always recovered after downturns. Instead, the risk is needing money when their investments are down temporarily.
It’s true that stocks swing more wildly than bonds, but that doesn’t necessarily mean they’re more hazardous to older investors than younger ones. How much risk investors can take depends mostly on how much money they need and when. Younger ones are more likely to need savings for big purchases, like a down payment on a home, furniture or childcare. It’s risky to put that money in stocks because it might not be there when they need it.
Many older investors, by contrast, draw a small percentage of their portfolio every year for living expenses, commonly a dollar amount that is 4% of their portfolio when they retire, adjusted for inflation every year. They can have most of their money in stocks regardless of age. As the withdrawal rate rises, so does the risk of having to pull out bigger chunks of the portfolio during downturns, for which a higher bond allocation can provide protection at any age.
One reason older investors underestimate their ability to own stocks is that they overestimate how long bear markets last. The median time from peak to recovery for the S&P 500 Index was about two years over the many bear markets since 1928, including dividends (the average was closer to three years). The notable outlier was the Great Depression, which took more than 16 years to get back to even. But a 60/40 US stock/bond portfolio with a 4% withdrawal rate would have held up even then. That’s because prices fell in the 1930s, requiring smaller withdrawals after adjusting for deflation; bonds rallied and helped offset the blow; and the market turned higher in the early 1930s, allowing portfolios to recover as withdrawals continued.
Nor is willingness to take risk necessarily related to age. Some older people are unbothered by the stock market’s gyrations, while some younger ones lose sleep over the market’s every tick. A smarter way to align investors with their portfolios is to target the amount of paper losses they’re willing to tolerate. A good heuristic for estimating such a number is to multiply the stock allocation by 40% and 50%. That provides the range of likely paper loss in a severe bear market. For example, a 60% allocation to stocks could result in a decline in the range of 24% to 30% before the portfolio recovers. Investors can dial their stock allocation up or down to their comfort level.
It’s hard to dislodge the dogma of age-based investing. There are trillions of dollars in target-date funds that mechanically increase their bond allocation as investors’ retirement age nears. Many investors and their advisers are also in the habit of reducing stock exposure with age. There are signs, though, that younger investors are rethinking long-held assumptions and building their own portfolios. Chatbots, which in my experience are more likely to encourage investors to think about risk in terms of ability and willingness than age, can help.
I’m not suggesting that investors abandon bonds. In fact, with yields back to more normal levels, bonds are likely to produce higher returns than they have in two decades. But stocks still offer a sizable premium, and they’re highly likely to outpace bonds in the long term. Investors who own more bonds than they need also risk falling behind inflation over time, which is what has happened to bond-heavy portfolios so far this decade.
That doesn’t mean everyone should own more stocks than bonds — only that investors shouldn’t base their allocations on age.
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