Investment Risk Profiling - Equities & Bonds

The real risk to financial independence is when approaching retirement and the years just after retiring. If there is a crash during these years whilst still invested in risky equities it can have quite a dramiatic effect on long term wealth and overall retirement prospects. This is why the standard advice is to move into bonds as retirement approaches.

The Glide Path

Before you start to buy funds it's worthwhile sitting down and deciding how much risk you want to take. Some people decide based on their age, and Vanguard describe this as the "Glide Path". When you're young you can afford to take long-term risks with your investments but as you get older a market crash in the equity market may cause problems. This means that you dial down risk as you get older. The primary source of risk in your portfolio will come from the equity component. This is because share prices are usually much more volatile than bond prices. This means that the risk you take depends primarily on the amount of equity in your portfolio. 

Own Your Age in Bonds

The rule of thumb that people often use is: Percentage Equity = 100 - age, If you're 20 years old according to this rule you would have 80% of your portfolio in equity and 20% in bonds. If you're 40 the split becomes 60% equity and 40% bonds. And if you're 60 it's 40% equity 60% bonds. Vanguard has a set of products called target-date funds where the whole fund is geared towards the time when you retire and follows a slightly more aggressive glide path than the 100-age rule. Until the age of 40 these funds are 90% invested in equity. This then gradually reduces to 50% equity at age 65, then falls more rapidly to 30% at age 72 years.

Of course you may be a very cautious 20 year old or an octogenarian that likes to take big risks so the idea of a glide path may not apply to you. However once you've decided on your risk profile stick with it. Don't keep chopping and changing as markets crash and rally. This is easier said than done because during a market crash the world seems like it's about to end and it is very difficult to stick to your investment strategy. 

During a rally it's easy to get tempted into increasing the equity component of your portfolio to squeeze every penny out of the markets. The thing to remember is that the biggest positive returns happen during market crashes and that if you're a long-term investor you should be willing to ride out these periods of volatility without panic selling. And during blistering rallies remember that nobody can reliably predict market crashes so it's always good to stay diversified just in case something bad happens