The following is an excerpt from Your Money Ratios: 8 Simple Tools for Financial Security.
It’s a hard time to be an investor. Markets are volatile and panic is in the air. Many people are questioning the conventional wisdom that buying and holding sound investments is the most reliable way to build long- term wealth. But is it? Or has the wisdom of 100 years been turned upside down by the events of the past few years? Let’s start by asking our Unifying Question:
“Will investing help move me from being a laborer to a capitalist?”
Probably. That’s because investing is a double- edged sword. If done prudently, it can help increase your capital and move you from laborer to capitalist. But if done foolishly, it can reduce your capital and move you the other way. My Investment Ratio represents the prudent and time- tested approach to building capital over the long term. I will fi rst cover the ratio and how it is designed to help you build and protect your capital. Then in the next chapter, I will get into a more detailed discussion about the fi nancial markets and investing to help put the Investment Ratio in perspective.
The Investment Ratio
There are two basic types of investments you can own: stocks and bonds. With stocks, you own a small part of a publicly owned company. With bonds, you are lending money to others with the promise that they will pay you back. Thus you can be an owner, a lender, or a little of both. One of the key questions in developing your investment strategy is, “What mix of stocks and bonds should I have?” Stocks carry greater risk and therefore offer greater potential returns; bonds are more conservative and therefore safer, but over time, your returns will typically be lower than with stocks.
The Investment Ratio sets forth the fundamental split between stocks and bonds that you should consider at different stages of your financial life cycle. This allocation will determine the vast majority of the risk you are taking and the potential return of your portfolio. It is the most important thing to get right when it comes to investing, and it is where most people make their biggest mistakes. Some investors make the error of being too aggressive and lose more of their capital than they thought possible. Meanwhile, other investors
are too conservative, which reduces the likelihood that they will reach their long- term capital appreciation goals. The ratio helps you curb both of those costly tendencies.
The ratio is simple to use. Just find your age, and then the corresponding allocation to stocks and bonds. For instance, a 45- year- old should consider an allocation that is approximately 50% stocks and 50% bonds. Later we will discuss why I believe this approach, which may seem conservative to some, is actually quite prudent, even if you are young.
Here is the Investment Ratio (for various ages):
- 25 years old -- 50% in stocks, 50% in bonds
- 30 years old -- 50% in stocks, 50% in bonds
- 35 years old -- 50% in stocks, 50% in bonds
- 40 years old -- 50% in stocks, 50% in bonds
- 45 years old -- 50% in stocks, 50% in bonds
- 50 years old -- 50% in stocks, 50% in bonds
- 55 years old -- 50% in stocks, 50% in bonds
- 60 years old -- 40% in stocks, 60% in bonds
- 65 years old -- 40% in stocks, 60% in bonds
It is important to note that this ratio is for general education purposes and is not an individual investment recommendation. Because investment decisions must be based on your particular circumstances, I recommend that you work with a qualified financial advisor to determine how to invest your savings. The Investment Ratio provides you with a framework for understanding risk and return that will help you work with an advisor and make more informed investment decisions. You may ultimately decide that you would like to follow the ratio, but this decision should only be arrived at after you have considered your individual circumstances and objectives.
50/50 at 25 is a bit conversative in my eyes. I'm currently at atabout 90/10. at retirement (age 60), I will move to the 50/50 mark.
Posted by: Anthony | April 28, 2010 at 07:26 AM
Anthony --
It's the same for me. I was interested to see all these splits -- most seem way too conservative.
Posted by: FMF | April 28, 2010 at 07:54 AM
It's a bit odd. Why did the writer make a list when essentially, he reccomends 50/50 under 60 years and 40/60 for 60 years old and up? I'm also in the camp that says that it's way too conservative. A 25 year old has almost fourty years to recoup any losses. Almost every other opinion including mine is that they should be much more aggressive than 50/50.
Posted by: rzrshrp | April 28, 2010 at 08:36 AM
Terrible advice...but what do you expect when you read a financial advice book by a LAWYER!
I'm sure as heck glad I didn't invest this way when I was younger...I'd have a small fraction of what I do now.
Posted by: Johnson | April 28, 2010 at 10:06 AM
I am currently 25 and almost every penny I have is in equities. I agree that the ratio's above are far too conservative. Certainly if you're under 30 most of your money should be in equities. I wonder why the writer is so conservative? Perhaps there is more in the book that explains, and FMF can enlighten us as to why.
Posted by: Learn Save Invest | April 28, 2010 at 10:20 AM
I agree with the commenters above...a 50/50 split when you're less than 30 years old is just plain wasteful. We are around 85% equities and 15% bonds and cash and that's a little conservative...what's stated above is just silly.
Since we want to retire by 52, we also are going to move to the conservative investment side quicker than most, but right now, less than 80% in equities at age 26 would just be nuts.
And, like rzrshrp, why bother making a list when there's only two options? He must have really been craving some extra page room of something...maybe his editor thought he needed more visuals...
Posted by: Budgeting in the Fun Stuff | April 28, 2010 at 10:29 AM
All --
I'll be covering the eight ratios more in depth as well as telling where I stand on each of them in some upcoming posts.
Posted by: FMF | April 28, 2010 at 10:35 AM
The simplest rule of thumb is that your bond allocation should approximate your age so that you're taking less risk as you get older and no longer have the time to recoup losses.
Posted by: The Biz of Life | April 28, 2010 at 10:43 AM
I think this is way too conservative. Stocks will outperform bonds in the long-run. It's only when you're approaching retirement and can't handle a 10 year decline in the market that it makes any sense to move money into bonds. It's not "prudent" for a 25 year old to put 50% into bonds, it's accepting a lower return on one's investments. If the stock market really was going to tank for 50 years, we might as well be worried that the whole US government would default on their debt, in which case bonds would be worthless.
Posted by: Chuckles | April 28, 2010 at 11:32 AM
definitely must be a typo as no 25 year old should have 50% of their money invested in bonds, that is way too conservative. but again, it all depends on what an individual can stomach in regards to volatility and risk. Some 25 year olds are scared to death of risk, so they might take this advice.
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Posted by: Stephan | April 28, 2010 at 11:35 AM
I am in the same camp as most other commenters. A 50/50 split is way too conservative for most young people. Can you actually make up the hidden loss of purchasing power by investing at 50/50 for 40 years? By how much will the ratio change AFTER the bond market tanks?
Posted by: ctreit | April 28, 2010 at 12:38 PM
Arbitrarily speaking, they do seem quite conservative.
I'm not opposed to the idea of someone suggesting "better" asset allocations, but what I would love to know isn't what %, but more importantly, WHY? Why is this a better allocation?
I guess I'll have to wait until the post to find out more.
Posted by: Eugene Krabs | April 28, 2010 at 03:32 PM
Getting 50% every 5 years really hard to invest, it should be like 20% percent every 5 year which would be easy and better way because the we never know, when we have to face the recession.
Posted by: Ronal E. Barron | April 29, 2010 at 04:07 AM
I think overall those allocations are borked.
But, I'll offer a view contraian to the traditional view. Your two main wealth producing assets are (i) your human capital and (ii) your financial capital. When you are young, your human capital is subject to much more risk than someone who is say 60 years old. If you take this approach there is a decent arguement to be made that young investors should probably have a higher weight of fixed income than the traditional view, middle age investors should be the most aggressive (because at this time their careers have probably solidified, etc.) and then older investors should move back to a more fixed income weighted allocation. This is essentially a view proferred by Laurence J. Kotlikoff (a professor of economics at Boston University). It's part of his "consumption smoothing" approach to financial planning.
Posted by: Bender | April 29, 2010 at 02:05 PM
@Bender: The way to compensate for the risk of losing your human capital is disability insurance, not over-conservative investing decisions.
Any money you don't need soon (within 5 years) should be invested in equities - regardless of age. If I am going to live to 85, then even at 55, I have some money that needs to grow for 30 years.
And you should treat any pensions, social security payments, etc. as equivalent to ultra-safe bond investments when calculating your ratio.
etc., etc.
Posted by: Mark | April 29, 2010 at 08:14 PM
if you follow intelligent investor by benjamin graham, you'll find that 50/50 is the most appropriate ratio for most of the public (even 60/65 yr old). graham provides wide range of scenarios and ages and helps you conclude that in absence of ability to predict future, 50/50 ratio is the one that makes most sense for majority.
Posted by: Param | May 20, 2010 at 03:45 AM
we are all missing something mentioned in the post:
===
Later we will discuss why I believe this approach, which may seem conservative to some, is actually quite prudent, even if you are young.
===
are we there yet???
Posted by: Param | May 20, 2010 at 03:50 AM
Param --
This is an excerpt, so it's not included. If you want more discussion of this ratio, go here:
http://www.freemoneyfinance.com/2010/05/the-eight-money-ratios-part-3.html
Posted by: FMF | May 20, 2010 at 07:59 AM