We all must be aware that diversification across Equity and Debt is the key to a successful investment. Do you ever wonder as to how can you decide the proportion of your investment in debt and equity?
The 100 minus age rule comes as a savior and helps you to take this decision. Read on and find more below.
What is the 100 minus age rule?
The 100 minus age rule is one of the oldest rules of asset allocation, which gives a sensible solution to decide the proportion of debt and equity in your portfolio. It says that the percentage proportion of equity in your portfolio should be equal to the difference between 100 and your age.
Let us understand this through an example:
Suppose your present age is 30 years old. Now, 100-your age (30) = 70. This means that 70 percent of your investments should be made in equity, while 30 percent of investments should be made in debt.
Clearly, this example illustrates the simple idea behind the rule i.e., the lesser the age, the higher the risk-taking capacity and the ability to handle the weather storms of the stock market. However, as you grow old, the risk-taking capacity reduces, and you would need your money sooner. In that scenario, it is essential that you invest in fixed income securities which ensure fixed returns.
Will the 100 minus age solve all your worries?
Let us understand this by continuing the above example.
Early Retirement: At the age of 30, your risk-taking capacity is high, and you can afford to spend a significant chunk of your wealth in equities (70%). But what if you plan to retire early say at the age of 50? Indeed, you will require your money sooner, but since due to the 100 minus age rule, 50 percent of your wealth will be invested in equities where the risk and return varies making your early retirement plan unsafe.
Late Retirement: On the other hand, what if you defer your retirement plan to say 70 years? In this scenario, you can afford to take risks by investing in equity, but you will be forced to book early profits in stocks and invest in debt.
The usage of 100 Minus Age rule raises essential questions:
How can risk appetite be simply a function of age?
Risk Appetite is a function of another important factor that is income. What if your income does not allow you to take risks even when you are young, say 30 years? You cannot rely on equities solely based on your age.
Shouldn’t the proportion of equity in a portfolio be a function of your risk appetite?
Every investor has a different risk-taking capacity. You might be risk-averse and a conservative investor even if you are young. Therefore, your risk appetite and not your age alone should determine your investments.
How should you then decide your asset allocation?
Apart from the risk appetite, other factors, which should determine your investments, are your time horizon and your financial goals. Investment in equities requires a longer time frame. So if you are willing to stay invested for a shorter time frame, debt funds should be your pick.
Investments should not be dependent on any single criterion throughout since no person's financial situation remains the same. It is, therefore, important that dynamic investment strategies are adopted throughout life.
One has to take the pains of identifying and applying different financial strategies, because of course… “Unless you take the pain, you will never be able to participate in the gain!”