Age plays an important role in determining asset allocation. The general consensus is, the older you get, the less risk you should take. This makes sense for two reasons: first, you have less time to make up losses, especially if you are in the distribution phase of life; and second, if you are still working, you have fewer years to replace those losses from savings.

A SIMPLE APPROACH

Financial planners use several asset allocation models to set asset allocation. One simple method that is popular with advisors and the media is known as "Your Age in Bonds." Very simply, whatever a person's age is, that is the allocation they should have in bonds. The remainder of their portfolio would be invested in riskier assets such as stocks.

For example, a 55-year-old may have 55% of his or her savings in bonds and the rest in a diversified stock portfolio. This allocation would change every year or every few years as the investor ages.

This concept definitely has the appeal of simplicity. It is easy to articulate to clients and appears to solve a difficult financial planning question about asset allocation.

However, is it practical to apply this general rule across your entire client base? While "Your Age in Bonds" may work as a starting point for asset allocation, our research shows the concept requires substantial adjustment as clients get older.

Different clients have different needs, and their chronological age may not be the best way to determine their asset allocation. While simple guidelines such as "Your Age in Bonds" make portfolio construction straightforward and convenient for the financial planner, these strategies may not represent the level of due diligence that should prevail when tailoring a portfolio for each client.

CHRONOLOGICAL AGE

Let's look at two age groups, 30-year-olds and 55-year-olds. We are going to test how well "Your Age in Bonds" works as an asset allocation formula for each of these groups.

Most 30-year-olds are still at the beginning of their careers or perhaps making their first career changes. They all have many years of work and savings ahead. Thirty-year-olds typically have little in savings, which means that market gyrations have only a minor impact on their net worth.

Accordingly, most 30-year-olds should concentrate more on formulating a regular savings plan, and whatever money they do save should be largely invested in equities as long as the allocation does not exceed their tolerance for risk. Consequently, a "Your Age in Bonds" allocation of 70% in equity and 30% bonds works fine for most people in this group.

The range of financial situations for people who are 55 is much broader than when they were 30 years old. Some 55-year-olds have accumulated significant wealth, while others have accumulated few assets and significant obligations. Some people are vested in an employer pension, while others are relying 100% on their own savings for retirement.

Family status is quite diverse also. Some people are married, others divorced, others remarried and still others never married. Some are caring for large families, some for small families, some have no family and some have extended families, with a wide variety of responsibilities to help out aging parents or other relatives. As financial advisors have come to know, appropriately dealing with unique life situations is a constant in the financial planning process.

Consequently, there is no typical 55-year-old for asset allocation purposes. Their situations are all unique, and their asset allocations need to take into account a host of life situation variables.

In general, it's more appropriate to create simple, age-based, all-purpose asset allocation models for younger people and less appropriate to propose them for older investors. Life has a way of intruding on our simplistic models and introducing lots of sticky details as we grow older, and those details should have a bearing on our asset allocation and investment portfolio.

ALLOCATION AGE

So is the "Your Age in Bonds" model useless? No, but financial planners need to make adjustments, and an important one is determining the allocation age of an investor. So far, we have only discussed chronological age as a proxy for asset allocation. Now we will take a look at allocation age, which takes life situations into account.

A person's allocation age may be higher or lower than his or her chronological age, depending on the individual investor's unique situation. In a sense, "Your Age in Bonds" is a fair place to begin forming an asset allocation, and then the financial planner should adjust the percentages either up or down based on factors unique to each individual.