As you get older, your bond allocation should generally increase from 0% to 10% in your 20s and 30s up to 40% to 50% by the time you reach retirement age. This gradual shift protects your accumulated wealth from stock market drops when you are close to needing the money.
The mechanics of age-based asset allocation
The main reason to increase your bond holdings as you age comes down to human capital and your investment time horizon. When you are young, your career represents a massive financial asset because you have decades of future earnings ahead of you. This allows you to take high risks with your investment portfolio. If the stock market crashes, you do not need to sell your investments, and your paycheck gives you the time and cash to wait for a market recovery.
As you approach retirement, your human capital shrinks because you have fewer working years left. Your investment portfolio must transition from a wealth-accumulation tool into a wealth-preservation tool. Bonds provide this preservation because they are fixed-income securities. They pay regular interest and do not experience the same wild price swings as stocks.
The underlying rule used by major financial institutions to manage this shift automatically is called a glide path. For example, a typical target date retirement fund keeps bond allocations very low until you hit age 40 or 50. After that point, the fund automatically sells a small percentage of stocks and buys bonds every year. This mechanics-driven approach ensures that a sudden stock market crash right before your retirement will not force you to delay your retirement plans.
Step-by-step breakdown of bond percentages by age
To map out your lifetime investment mix, you can use modernized variations of classic financial guidelines like the rule of 110 or the rule of 120. Subtracting your age from these numbers gives you your stock percentage, while the remainder goes into bonds.
- In your 20s and 30s (0% to 10% bonds): Your focus is entirely on long-term growth and compounding. You should keep almost all of your money in equities since you have more than two decades to ride out any major economic downturns.
- In your 40s (10% to 20% bonds): You are entering your peak earning years. You should introduce a small, stable baseline of broad-market bond funds to act as a stabilizer without heavily dragging down your portfolio growth.
- In your 50s (20% to 35% bonds): Retirement is now visible on the horizon. You must start accelerating your bond purchases to protect your principal against sequence-of-returns risk, which is the danger of a market crash occurring right before you stop working.
- At retirement age 65 and beyond (40% to 50% bonds): Once you stop earning a salary, your portfolio must generate reliable income. Maintaining a large bucket of bonds ensures you have several years of living expenses secured in safe assets, allowing your remaining stocks time to grow.
The outdated rule of thumb to avoid
The biggest trap investors fall into is blindly following the traditional rule of 100, which states you should subtract your age from 100 to determine your stock percentage. If you are 60 years old, this old formula dictates you should hold 60% of your portfolio in bonds and only 40% in stocks.
Following this rule today is a major mistake that can cause you to run out of money in retirement. People are living significantly longer than they used to, and bond yields fluctuate over time. If you move more than half of your portfolio into low-growth bonds at age 60, your portfolio will likely fail to outpace inflation over a 25 or 30 year retirement retirement window.
You must maintain a healthy allocation of stocks even during retirement to keep your purchasing power alive. Treat your bond allocation as a cushion to cover your short-term spending needs, not a complete replacement for growth-generating equities.