What is the ‘100 minus Age’ Rule and Why is it Wrong for Equity Allocation?

Retirement corpus is akin to planting a seed that requires time to grow into a tree that gives us assistance when we need it the most.

The 100 minus age rule for equity allocation is a simple formula that suggests how much of your portfolio should be invested in stocks based on your age. According to this rule, you should subtract your age from 100 and invest that percentage of your portfolio in stocks. For example, if you are 30 years old, you should invest 70% (100-30) of your portfolio in stocks and the remaining 30% in bonds or other less risky assets. The idea behind this rule is that as you get older, you should reduce your exposure to riskier assets and increase your allocation to safer ones.

First things First - Understanding the term ‘Portfolio’

We often get confused with the term ‘Portfolio’ consisting of only  liquid assets like Fixed Deposits, Mutual funds, stocks, etc. However, portfolio means our entire networth which also include Real Estate and Gold, etc. Hence, whenever we use the ‘100 minus age’ formula for arriving at optimum Equity allocation, we should also consider other asset classes like Real Estate and Gold for arriving at the equity percentage allocation.

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Why does the formula suggest higher Equity allocation at younger age and gradual reduction as we age?

The logic behind this formula is that younger investors have a longer time horizon and can afford to take more risk with their investments, while older investors have a shorter time horizon and need to preserve their capital and income. By gradually reducing the equity allocation as you age, you can lower the volatility and risk of your portfolio. 

The formula assumes that Equity is a higher risk asset class as compared to Real Estate, Debt or Gold due to Volatility. Accordingly, to avoid uncertainties at the time of retirement when we don't have any other source of income, allocation towards Equity is being reduced.

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What are the drawbacks of using the 100 minus Age formula for Equity Allocation?

Misconception called Equity is Risky Asset

As I explained in my post How is Risk misunderstood, Volatility is not Risk. Volatility gets eliminated or mitigated if our investment horizon is more than 10 years. Why 10 years? It is because generally an economic boom and recession cycle lasts between 5 to 10 years. Accordingly a bull and bear market cycle is assumed to last between 5 to 10 years. 

Present retirement age is between 58 to 60 years. Present life expectancy in India is 70 years and has been increasing year on year. Accordingly, investment horizon after retirement will most likely be more than 10 years. Hence, Equity will no longer be a Risky investment as compared to Gold or Real Estate for this time horizon. 

Not taking Equity allocation is a bigger risk

As per this article on livemint, a list of how various asset classes have delivered in terms of returns in the last 10 years (2011-2020) are as under:

As can be observed, over the long term (i.e. 10 plus years), equity has beaten all other asset classes in terms of returns. Even in earlier periods also, Equity has beaten all other asset classes. Accordingly, by not investing in equity as we age, we are compromising on returns. 

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Counterview

We often get a counterview quoting Nikkei 225’s poor performance over the past 30 years. 

Nikkei 225 is a stock market index based out of Japan. It  has not given any returns in the past 30 years. 

My response to this counterview is that India is not Japan. Japan has an aged population. India has a young population. Japanese economy became a developed economy by the 1990s. India is still a developing economy.  Further, India’s nominal GDP per capita was $1,940 in 2020. This was lower than many other developing and developed countries such as China ($10,484), Brazil ($6,450), South Africa ($4,980), Russia ($9,877), UK ($39,229), USA ($63,416), Germany ($45,466) and Japan ($35,291). Indian economy is still developing and there is still a long runway for growth for many years to come. 

Accordingly, equity performance of the Indian stock market is likely to outperform all other asset classes for multiple years to come. 

Small % difference in returns can lead to big difference in terminal corpus

While % difference in performance between Equity and FDs look small at a difference of only 4.5%. If we consider equity to continue generating long term returns of 13.2% vs FDs (debt) of 8.7%, then over a 20 years time horizon, corpus in equity will multiply 12X times and corpus in FDs multiply 5X times which turns out to be a very significant difference.  Hence avoiding equity allocation is a bigger risk.

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What is the best strategy to withdraw a fixed amount of cash from our stock portfolio every month without losing too much value due to market fluctuations?

In Real Estate or Fixed Deposits (Debt), we can easily withdraw money on a monthly basis in the form of rental income or Interest. However, we often face the dilemma of whether we can withdraw from equity due to market fluctuations. Withdrawing money from portfolio is critical after retirement to meet our expenses as we will not have any other sources of income. 

The 4% withdrawal rule comes to our rescue. As per the 4% withdrawal rule, if we withdraw a maximum of 4% of our equity portfolio every year to meet our expenses after retirement, then the corpus will not get depleted even during bear market phase.It implies, we need to have a corpus of atleast 25 times our annual expenses at the time of our retirement to meet the 4% rule. Any amount less than that, then we need to avoid equity all together after retirement. 

A more conservative rule is the 2% withdrawal rule i.e. we need to have atleast 50 times our annual expenses as a retirement corpus..

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