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The recurring question on most investors' minds is how much should I invest in stocks or bonds. This question has been answered through rules of thumb like "100 minus your age," which provides your percent allocation to equity. However, there are myriad factors to consider other than an investor's age or time horizon, which should also be accounted for (e.g., liquidity needs, risk tolerance, taxes, legal concerns, and unique circumstances). This article is not meant to design an optimal portfolio that will be applicable to any investor given any circumstance, but to show why the commonly held perception that young investors should be aggressively weighted in equity and rules of thumb like "100 minus your age" are not necessarily the optimal decisions for asset allocation.

Problems with investing aggressive at a young age

Let's assume you are 20 years of age right now and plan to retire at age 70. That gives you a 50-year investment time horizon to generate a retirement nest egg. You may think let's dump all of my retirement savings into stocks because they typically generate better returns. However, the stock market is not guaranteed to be higher at the end of 50 years. When looking at some historical equity returns in other developed economies, the assumption that stocks will always be higher given a long enough time horizon begins to be seriously questioned. In Japan's stock market for example, the Nikkei 225 index (NYSEARCA:NKY) closing price on January 4, 1984, was 9,927 (oldest index value on Yahoo! Finance) and the price as of January 24, 2012 is 8,785. After a 28-year investment period, this index is still down 12%. In this scenario, asset diversification would have been extremely important.

Many investors might say that Japan's situation is a corner case that should be ignored for modeling long-term capital market expectations. I would have to agree; however, although the U.S. stock market is likely to be higher at the end of 50 years, that doesn't mean having a positive outcome also means that the optimal decision is to invest aggressively in stocks. What if you would have made much more investing in bonds instead of stocks or a portfolio holding a combination of the two?

The question now becomes, what is the optimal asset allocation for long-term investing. This is difficult to answer given that the past is not indicative of the future. However, by generating a Monte Carlo simulation on historical equity and bond returns, investors can see the range of outcomes that could be expected for various asset allocation strategies.

Monte Carlo Simulation Methodology

For this simulation, I looked at constant mix strategies ranging from all bonds to all equity and combinations in between as well as analyzing the "100 minus your age" rule of thumb.

First, I separated the 50-year time period from 1960 to 2009 into 10 separate 5-year regimes to recreate how the portfolio would have performed if the past occurred in different sequences. For example, this would allow an investor to see how the strategy would have worked if returns during 2005 to 2009 occurred in the first five years of the simulation and if 1960 to 1964 simultaneously occurred during the last five years. I used these 5-year regimes to generate 25,000 unique randomized 50-year scenarios. Note, rearranging historical stock and bond performance impacts the final portfolio value. For example, if the best 5-year period occurs at the end of the simulation vs. the beginning, the final portfolio will be larger because the investor has a larger portfolio (from regular contributions and past appreciation / income) upon which to apply those returns.

I decided to use 5-year regimes because the average length of economic cycles according to NBER is 55 months or approximately 5 years. Additionally, by using a 5-year time period, this provides enough time for the mean reversion in equity to occur. If you used single-year returns in a Monte Carlo method, then your model could end up sequencing the worst equity returns together over the past 50 years. For example, combining the seven worst annual returns during this time period [1966 (-10.36%), 1973 (-15.03%), 1974 (-26.95%), 2000 (-9.11%), 2001 (-11.98%), 2002 (-22.27%), 2008 (-37.22%)] generates a price decline of 78%, which is unlikely. However, combining returns in groups of five years eliminates nonsensical strings of returns from occurring while allowing enough flexibility to generate a wide distribution of simulation results.

The constant mix strategies were rebalanced at the end of the quarter and dividends and interest earned during the quarter were reinvested at the end of the quarter as well. Stock returns are based on the historical returns of the S&P 500 including dividends (NYSEARCA:SPY). Bonds returns are based on a 25-year constant maturity exposure to AAA corporate bonds. The simulation assumes that the individual begins with a $10,000 portfolio at age 20 and makes a quarterly contribution of $2,500 until the end of the simulation.

Monte Carlo Simulation Outcomes

As highlighted below, the rule of thumb strategy "100 minus your age" underperforms two constant mix strategies at nearly every percentile of return: 60% equity / 40% bonds and 70% equity / 30% bonds. These constant mix strategies provide more upside potential while also outperforming on the minimum return scenario.

The reason why the "100 minus your age" strategy underperforms these constant mix strategies is due to the effects of market timing and asset allocation. If stocks underperform when you are younger (more equity exposure), but outperform when you are older (less equity exposure), then you will have avoided the beneficial returns from holding riskier stocks.

Therefore, the best strategy to maximize your minimum ending value while still outperforming the "100 minus your age" strategy is a 60% equity / 40% bonds constant mix, as shown in the table below.

(Click chart to expand)

The actual column shows how the past actually performed for each allocation strategy (actual performance history from 1960 to 2009). The "100 minus your age" strategy actual performance was at the 78%ile for that strategy's simulation results. Therefore, part of this strategy's popularity might be driven by its successful implementation for many investors over the past 50 years (strong equity returns during younger years and strong bond returns in older years). Note, allocations incorporating bonds experienced actual returns significantly outperforming simulation results due to a sustained bond rally over the past several years caused by the Fed's monetary easing efforts. This explains part of the outstanding performance of the "100 minus your age" strategy over the past 50 years because the strategy was overweighted in bonds during the Fed's monetary easing efforts.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Disclaimer: Please consult your financial advisor before making investment decisions. Depending on your circumstances and risk tolerance, the strategy in this article may not be suitable for all investors.

Source: Debunking The '100 Minus Your Age' Rule Of Thumb