It’s a time-honored, rule of thumb used to determine how much you should invest in stocks, bonds and cash. You subtract your age from 100 (or some prefer 110) and the result is the percent you should invest in stocks.
So, for instance, if you’re 30-years-old, you would invest 70% of your money in stocks and 30% in bonds (100-30=70.) And, if you’re 70-years-old, you would invest 30% of your money in stocks and 70% in bonds (100-70=30).
This rule of thumb is “approximately right,” said Zvi Bodie, a professor emeritus at Boston University. “But not for the reason that most people thought,” he said. “It's not that stocks become less risky in the long run, which is the conventional wisdom.”
Rather, it has to do with how you allocate your assets given your total wealth over the course of a lifetime. And your total wealth includes your financial and human capital (the present value of your future earnings), and some might argue your social capital (Social Security).
Bodie’s mentor, economist and Nobel Prize winner Paul Samuelson, took up this question in his 1969 paper, Lifetime Portfolio Selection By Dynamic Stochastic Programming.
“What Samuelson showed was that with a reasonable economic model of optimization under uncertainty, your age has no effect on the fraction of your total wealth, total wealth that you would invest in stocks,” said Bodie.
So, for instance, when you’re in your 20s you have a large percent of your total wealth in safe assets (your human capital) and, likely, a small amount in risky assets (financial capital). And so it would make sense for someone just starting out in their career to invest the bulk of their money in risky assets.
“Your retirement portfolio, which is tiny relative to your human capital, all of it can be invested in the risky asset,” said Bodie. “In fact, you might even want to lever it up to get a little bit more exposure to equity.”
But as you age, your human capital becomes a smaller portion of your total wealth (you have fewer years of earnings) and your financial capital, your retirement portfolio, becomes a larger portion of your total wealth.
“So, therefore, you're going to decrease the portion of the portfolio that is invested in equities,” said Bodie. “So bottom line, the fraction of your total wealth invested in equities will remain constant.”
And that, said Bodie, is the Samuelson explanation. “But it's not that equities become less risky. Equities over time do not become less risky,” he said.