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Asset Allocation for Young Investors

I recently had the pleasure of attending a Q&A session with a few Vanguard executives and fund managers. One of the questions asked was why the Vanguard Target Retirement funds have such a stock-heavy allocation for young investors (90% stocks, 10% bonds for investors more than 25 years from retirement).

John Ameriks (the head of Vanguard’s Investment Counseling & Research group) replied that the majority of a young investor’s total economic wealth is in the form of “human capital” (that is, future earnings from work), so Vanguard uses a high-risk portfolio to balance out the large, low-risk human capital asset.

Is Human Capital Low-Risk?

My problem with that line of thinking is that — if what I’ve seen from my friends, family, and classmates over the last several years is anything like normal — the typical 20-something’s work income is anything but low-risk. More often, it’s a relatively unpredictable rotation between periods of employment, unemployment, and underemployment.

If I were to suggest an allocation to balance out the human capital of a typical member of Generation Y, I’d suggest something conservative rather than aggressive.

Should Young Investors Have Conservative Allocations?

Despite my qualms above, I still think stock-heavy allocations make sense for many young investors. While the last decade has been lackluster for stock returns, I’m still convinced that the longer you hold stocks, the more likely they are to have positive returns, and the more likely they are to outperform lower-risk investments.

For a young investor trying to determine whether an aggressive allocation is appropriate, I think the two most important questions are:

  1. How certain are you that the money in question will not need to be spent within the next 20 years or so?
  2. What’s the most that your portfolio could decline before you started to get nervous?

If you know that the money will not be needed before retirement and you are confident that you would be comfortable with declines in the range of 40-50%, then I think a stock-heavy allocation is quite reasonable.

On the other hand, if you’re not comfortable with large declines, a stock-heavy allocation is a poor idea. One instance of panic-selling during a market low can be more than enough to offset any extra gains that you might get from allocating more to stocks.

Similarly, for young people with uncertain job prospects and little certainty that their investable money will ultimately be retirement money, a more conservative allocation makes a lot of sense. For money that’s a cross between retirement savings and an emergency fund, it makes sense to use an allocation that’s somewhere between the allocation you’d use for either one.

In other words, there’s more to asset allocation than just age. Conventional wisdom may say that most investors your age should be loading up on stocks. But that doesn’t necessarily mean that you should.

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  1. Another reason for any investor to hold some percentage of bonds (at least within a tax-deferred account) is that the bonds can be used to buy more stock when stock prices decline below the investor’s target allocation.

    BTW, Mike, did you see that your Retirement book got a mention in the latest AARP Magazine?

  2. Hi Larry.

    Good point about the usefulness of having bonds in order to benefit from rebalancing.

    And, yes, I did hear about the AARP mention. Thank you for the heads-up though. 🙂

  3. Mike,

    I definitely agree with you: age does not dictate asset allocation, although it is a factor in determining it. I’m 22 and have been investing only since June of this year; if I had gone with a 90% stocks/10% bonds when I started, I would have been eating nothing but red ink the whole way. It’s funny, because almost everything you mentioned was a factor for me (of course there were others as well) in determining how I was going to allocate. Thanks to reading your blog as a part of doing my homework, I’ve learned a lot and have (so far at least, lol) been relatively successful in the market! I’ll definitely be in a better position in the future than most in my age-group, that’s for sure!

  4. Given that the savings rate is the most important factor for young investors, I think young investors should adopt a more conservative asset allocation. If the loss from a stock-heavy portfolio discourages savings, an aggressive allocation does far more damage to the young investor than the loss itself.

  5. TFB,

    That’s a good point. I have a tendency to think of worst-case-scenario for a young investor being that they bail out on their portfolio and sell near a market low. But you’re right. The worst case scenario is much worse than that — they get discouraged from saving completely.

  6. Mike,

    As a young investor I really have to agree with this post and currently use a 80/20 asset allocation instead of the Vanguard Target Funds.

    I have been a big fan of your blog and it has guided me for the last year. I mention you in this boglehead post and was wondering if you wouldn’t mind commentating because I very much value your opinion.

  7. Hi SobeCane.

    I’m happy to hear you’ve been enjoying the blog. I just posted a reply on the Bogleheads thread you linked to.

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