It is often said that percentage of stocks that one should own in their investment portfolio is 100-minus their age. Is this a good rule of thumb? I am not sure where this “rule” originated, but like most “rules of thumb,” it may or may not be the best application to your situation.
Let’s start with what stocks are and how they impact our investment returns. Stocks are literally shares of ownership in a company. If you own Microsoft stock, you own a part of the company, just like Bill Gates does, but likely in a much, much smaller proportion. What does this ownership do for you? As an owner, you participate in the profitability, or lack of profitability, of the company. If they make more revenue than their senior leadership wants to invest back into their operations, those excess profits are distributed as dividends. If that same leadership has shown great vision and led the company to greater success, that success is reflected in your wealth through an increase in value of the company, as exhibited by a higher price for the stock.
Other than for interesting cocktail party conversations, why invest in stocks? Because historically, the value of your money grows faster than inflation can erode its value when invested in stocks. Ownership in companies are the only way to beat the inflation monster. The hard part of owning stocks, though, is they can be volatile. Everyone loves the upside of volatility, when prices go higher and higher. It is when stocks are volatile on the downside that people get nervous, and sometimes downright terrified. At that point, people tend to react and no longer act like rational investors, tempted to sell their holdings at the worst possible moment. Some of these periods of negative stock market returns can be scarring. Since the 2008 financial crisis, I have found people to be much more nervous about owning stocks, and it still affects their behavior more than a decade later – a decade of amazing stock returns.
However, since owning stocks is the only way to truly grow our wealth, people need to own them, even if the concept scares them. This brings us to our rule of thumb question. How much of each person’s wealth should be invested in stocks? This brings me to the answer my CPA always gives me, no matter what question I ask him: “it depends.” Here are a few factors to consider:
- Can you sustain your lifestyle if there is a prolonged downward turn in the market? If such a high percentage of your wealth is invested in the stock market that you cannot wait for a market recovery before you access the money, no matter what your age, you may need to reduce how much of your funds are invested in stocks.
- Will you spend most of the money on yourself, or leave a large portion to your heirs? This goes into the “lifespan” of your funds. If you do not anticipate needing all or most of your investments, but your heirs who are 30 years younger than you would likely inherit them, then the use of your funds is much longer than your life expectancy. A 35 year old heir will have much longer for investments to grow and also to recover from any market downturns than a 65 year old would, so the investments with a longer “lifespan” can withstand the higher volatility of owning more stocks.
- Consider not what your age might be, but what your time horizon is. Someone who retires at age 65 can often expect to live another 20-25 years. The biggest threat to retirement lifestyle is not volatile stock market returns, but inflation. The only way to grow your money faster than the rate of inflation is to invest it in the stock market. Living another 20-25 years gives inflation a long time to have a large impact on one’s lifestyle. We should be more worried about inflation than short term market movements!