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Age-based investing has some problems, experts say

With money from a summer job, financial advisor Rick Ferri's daughter made her first stock market investments in 2008. Soon the markets—and her investment—tanked. Though just 20, she panicked and told Ferri, president of investment management firm Portfolio Solutions, that she couldn't stomach the volatility and was ready to call it quits.

Though Ferri talked his daughter out of selling, the story emphasizes why investing based solely on age—an increasingly popular way for investors to access diversified portfolios—can lead them astray. Most young investors, after all, don't have a father who is a financial advisor, who can talk them out of selling at the wrong time.


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Age-based investing, most common with target-date funds in 401(k) plans, steers investors toward an asset allocation that is supposedly optimal for someone their age. But it may be too simplified for most investors.

"The emphasis on age is overdone," Ferri said. "It's better than when people were defaulted into stable value funds or money market funds, but it's not right for everyone." (Stable value funds are signed to preserve principal rather than pursue portfolio appreciation, similar to money market funds.)

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Most models say that young investors should go heavy on stocks and taper to a smaller equity allocation along a glide path—that's the investing-industry term for how a diversified portfolio's risk/return profile should be adjusted as one ages. Younger investors should have more risk tolerance because they have time to recover early portfolio losses, the thinking goes.

That might be the right approach in theory, but in practice it may not suit every investor. "I think we need different flavors of age-based investing that would match it more to risk preference," said David Blanchett, head of retirement research at Morningstar Investment Management.

"It's obviously not ideal for every 55-year-old to have a portfolio that's 60 percent stock, 40 percent bonds. We all have different risk tolerances." -David Blanchett, head of retirement research at Morningstar Investment Management

Below are five problems that advisors see with age-based investing.

Problem #1: Age and risk tolerance aren't the same. As Ferri's anecdote shows, not all young people have the risk tolerance they're assigned. Millennials, in particular, are risk averse and shy away from stocks. According to personal finance website Bankrate.com, only 26 percent of people under 30 own stocks at all.

Millennials lived through the dot-com crash, the housing bust and the financial crisis, all of which eroded any confidence they had in investing.

"Maybe some young people should not go high in equities initially," Ferri said. "Maybe they need to live through a couple of bear markets and they'll realize that stocks do come back, and get some tolerance into their system to be able to stay the course."

Problem #2: Older investors may be better at handling risk. By the same token, some older investors, given their experience with the rise and fall of stocks, have plenty of risk tolerance. "It's obviously not ideal for every 55-year-old to have a portfolio that's 60 percent stock, 40 percent bonds," Blanchett said. Also referred to as the 60-40 rule, that's the classic equity/bond asset allocation. "In reality, we all have different risk tolerances that require us to take on different portfolios," Blanchett said.

Advisors say that investors should focus on time horizon.

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Richard Kagawa, a certified financial planner and president of Capital Resources and Insurance, has clients who are in their 70s and 80s with portfolios mainly in equities.

Their cash needs are met with other assets, and they plan to leave their nest eggs to their children. "Their time horizon is actually their children's time horizon," Kagawa said.

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Problem #3: It ignores what else is going on in investors' lives. Some investors have pensions. Others are supporting older parents. Others have paid off their mortgages and have no debt. Asset allocation needs to take into account other assets and financial obligations, observers say.

"Someone with a large net worth or someone with a strong pension income can afford to take a little bit more risk with their assets," said Greg Hammond, CFP, CPA and president of Hammond Iles Wealth Advisors.

Problem #4: There's no way to respond to market conditions. Today's rock-bottom interest rates could mean that portfolios for people nearing retirement could be taking on more interest-rate risk than in previous years.

"A lot of these [asset allocation] rules may have worked really well for the last 30 years, when interest rates were coming down and bonds did really well," said Hammond, referring to the possibility of a rise in interest rates. "What was thought of as the conservative part of the portfolio may become very risky," he added.

As U.S. interest rates rise, U.S. bond prices—and the net asset value of bond funds—decline, because of the inverse relationship between bond yields and bond prices.

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What's more, since asset-allocation changes in age-based funds happen only as investors age, they have no ability to take broader market conditions into account, said CFP and America's Retirement Store vice president Marla Mason.

"In 2008 and 2009, target-date funds tracked very similar to the S&P 500," Mason said, adding that investors close to retirement saw their portfolios drop sharply in these funds. "They need to be doing something more to capitalize on up markets and protect more on down markets, especially for people close to retirement."

Problem #5: Heavy bond exposure dooms retirees to below-inflation returns. Most age-based models call for a bond allocation between 30 percent and 40 percent in the years leading up to retirement, rising sharply in retirement.

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Though inflation is -0.2 percent now, it has topped 2 percent in recent years. Bond funds yielding between 2 percent and 3 percent could have a hard time keeping up with rising costs. Medical care expenses—a major cost for many retirees—are expected to rise 6.8 percent in 2015, according to a report from PwC's Health Research Institute.

By having a big bond allocation, "you are condemning a client to never outpace inflation," said Kagawa at Capital Resources and Insurance.

—By Ilana Polyak, special to CNBC.com