Thumb rules can be conveniently useful for generalisations. But you need more than just a thumb rule to properly manage your investments. You should not use a thumb rule as a hard iron law that is 100% certain.
The thumb rule we are about to discuss, and more importantly, highlight its limitations, is the Age-based asset allocation of 100 Minus Age.
What is ‘100 Minus Age’ rule for equity allocation?
As per this thumb rule that is used to decide an investor’s equity allocation, you need to subtract your age from 100 to arrive at the ideal equity allocation. For example, if your current age is 40, then the rule says that you can invest up to 60% in equities (calculated as 100 minus your age 40, i.e., 100-40 = 60%).
As you might have extrapolated from this rule is that as you age, you need to allocate lesser money to equities.
To be fair, the thumb rule is simple and well-intentioned. It advocates that with rising age, people’s risk appetite might reduce and hence, equity allocation should go down as well. But that is too simple a rule and misses a lot of other important factors as play here.
Limitations of the 100 Minus Age rule
Assume you are a 35-year unmarried person with no dependencies or liabilities.
You have a 35-year-old friend, who is married, has 2 kids, 2 dependent parents, is the sole earner of the family and to top it all, has a home loan and a personal loan as well.
Do you think both of your risk appetites will be the same?
No not at all!
The circumstances for both of you are like night and day.
And that is the problem.
This rule assumes that every one of the same age has the same risk appetite and hence, gives them the same equity allocation (100-Age). But age should not be the only deciding factor for an investor’s asset allocation. Investors’ risk appetite, their goals (priorities & timelines), income, existing assets, financial responsibilities, liabilities and return requirements are to be considered as well.
The thumb rule gives no weightage to an investor’s circumstances or requirements at all. It just buckets everyone of the same age in the same risk bucket.
Better alternative investment strategy?
There is no one common thumb rule that can replace a proper strategy. And the best approach is to use the Goal-based Investing approach.
Here is how it works.
It is quite simple to understand and extremely logical.
Depending on your risk appetite and each goal’s time horizon, this strategy will customise how much to invest in equity and debt for each goal.
So, if you are a 40-year-old with 3 goals - 2 years (house downpayment), 9 years (daughter’s graduation) and 20 years (retirement), then you will follow different allocations for different goals. So, your 2-year goal will have 100% in debt as it is too short a time period for any risk-taking. The 9-year goal can have 50:50 in equity and debt while the 20-year goal can have 70:30 in Equity: Debt.
Compare this with using the 100 Minus thumb rule which would have suggested 60% equity allocation for a 40-year-old.
As you saw above, goal-based investing considers your time horizon, understanding and appetite for risk, and expected returns before deciding on the right asset allocation. And that is the reason it is a far better approach than age-based thumb rules.
Remember that personal finance is more personal and less finance. So, there can never be one rule that fits everyone correctly. You must give proper weightage to different factors, requirements, and circumstances before planning your investments. Your risk profile and investment goal time horizon must always be the primary factors influencing your investment allocation strategy.
Not just the 100-Minus-Age but almost all the thumb rules are theoretical in nature and applicable at an aggregate level for large sample sizes. So, you should not rely on them blindly, more so for something as important as your investment planning.
And if you are confused with the financial options at your disposal and unable to choose correctly, then it is wiser to take help from an investment advisor. They can work with you, assess your risk profile, analyse all your goals, your income and surpluses and existing investments and then create a proper financial plan that helps you get your finances back on track.
Dev Ashish is a SEBI-Registered Investment Advisor and Founder (Stable Investor). He provides fee-only financial planning and investment advisory services to small and HNI clients across India.