A. Many of us are familiar with and follow the "120 minus your age" investing framework. It says that you should subtract your age from 120 and invest that percentage in equities, putting the rest in fixed income. For example, a 50-year-old would be 70% (120-50) in equities and 30% (100%-70%) in fixed income. (Note that the rule used to be 100 instead of 120 but has since been revised due to increasing life spans.)
The rule-of-thumb is based on a couple of key concepts:
- Equities have higher potential return, but also higher potential risk, than fixed income.
- The younger you are, the greater your ability to take on risk and recover from adverse outcomes (market downturns).
- The older you are - and the closer you are needing to use your money in retirement - the less risk you should take.
So, as you age and get closer to retirement, you dial down your equity allocation as you move money to fixed income. The rule of thumb has its limitations, but in the absence of knowing more about someone, their risk tolerance, and their cash flows, it does a good job of guiding people towards the right investment mindset and outcomes. Most "Target Date" retirement funds work this way.
But today, I want to challenge one aspect of the rule of thumb, and that is that we got the type of fixed income wrong. It should be annuities, not bonds.
Keep reading the next blogpost in which we will clarify some definitions first.