Recs

291

Step 8: Cover Your Assets

As fun as finding winning stocks is (and trust us, it really is fun), your allocation to stocks (equities) is only one slice in your total investing pie. Asset allocation basically comes down to how much you should have in cash, how much in bonds, and how much in stocks. The Fool's four rules for asset allocation will help you slice up your portfolio into these important pieces.

Rule 1: If you need the money in the next year, it should be in cash.
You don't want the down payment for your vacation home to evaporate in a stock market -- or bond market -- crash. Keep it in a money market or savings account. And, of course, make sure it's FDIC-insured.

Rule 2: If you need the money in the next one to five years, choose safe, income-producing investments such as Treasuries, certificates of deposit (CDs), or bonds.
Whether it's your kid's college money or the retirement income you'll need in the not-so-distant future, stay away from stocks.

As with all investments, risk and reward go hand-in-hand when it comes to "safe" assets. So, in order of "safest" to "still safe but technically riskier," we have Treasury notes and bills, CDs, and corporate bonds. That's also the order of lowest to highest yield. CDs are still very safe (as long as they're FDIC-insured!), and they can usually be bought commission-free. Shop around for the best rates; your local bank may not offer the best deal.

As for corporate bonds, the general rule is to choose bond mutual funds over individual bonds if you have less than $25,000 to invest. However, keep in mind that bond funds can actually lose money, which can be awfully inconvenient if it happens right before you need it.

Stick with funds that focus on short- to intermediate-term bonds. And be vigilant about costs -- you can find plenty of good funds with expense ratios below 0.50%.

Rule 3: Any money you don't need within the next five is a candidate for the stock market.
We Fools are fans of the stock market, and we know our history (with a little help from Ibbotson). Here's how stocks, bonds, and Treasuries have fared historically:

Geometric Mean Returns (1926 through 2008)

Asset Class

Average Annual Return

Large-Cap Stocks

9.6%

Long-Term Government Bonds

5.7%

U.S. Treasury Bills

3.7%

Of course, that's one long time frame, and in the short run, no one knows what stocks will do. But make no mistake: Even if you're in or near retirement, a portion of your money should be invested for the long term. That's because, according to the Centers for Disease Control, a 55-year-old can expect to live another 26 years. A 65-year-old has another 18 years ahead of her. The average 75-year-old lives into her late 80s. A 110-year-old, however, should sell everything and get to Vegas while he still can. (Kidding … mostly.)

So unless you're a 95-year-old skydiver who smokes, expect your retirement to last two to three decades. To make sure your portfolio lasts that long, you should ...

Rule 4: Always own stocks.
Over the long term, equities are the best way to ensure that your portfolio withstands inflation and your retirement spending.

According to Jeremy Siegel's Stocks for the Long Run, since 1802 stocks outperformed bonds in 69% of rolling five-year investing periods (1802-1807, 1803-1808, etc.). The percentage of the time that stocks whoop bonds only improves as you look over a longer horizon.

Holding Period

Stocks Outperform Bonds

3 Year

67%

5 Year

69%

10 Year

80%

30 Year

99%

Data from Stocks for the Long Run, by Jeremy Siegel.

For holding periods of 17 years or more, stocks have always beaten inflation, a claim bonds can't make.

The bottom line is that when you need your money will partially dictate where you put it. What else determines your asset allocation? That favorite term among financial gurus: your tolerance for risk.

Risk drives return
Most people base their investment strategies on the returns they want, but they have it backward. Instead, focus on managing risk and accept the returns that go along with your tolerance for it. It'd be great if we could get plump returns with no risk at all. But to achieve returns beyond a minimal level, we have to invest in things that involve some possibility that we'll lose money.

So ask yourself: What would you do if your portfolio dropped 10%, 20%, or 40% from its current level? Would it change your lifestyle? If you're retired, can you rely on other resources such as Social Security or pensions, or would you have to go back to work (and how would you feel about that)? Your answers to those questions will lead you to your risk tolerance. The lower your tolerance for portfolio ups and downs, the more bonds you should hold in your portfolio.

As an extra aid in determining your mix of stocks and bonds, consider the following table, from William Bernstein's The Intelligent Asset Allocator:

I can tolerate losing ___% of my portfolio in the course of earning higher returns

Recommended % of portfolio invested in stocks

35%

80%

30%

70%

25%

60%

20%

50%

15%

40%

10%

30%

5%

20%

0%

10%

So, according to Bernstein, if you can't stand seeing your portfolio drop 20% in value, then no more than 50% of your money should be in stocks. Sounds like a very good guideline to us.

OK, you now know how much you should have in stocks. But what kind of stocks -- large caps, small caps, value, growth, international? And how much? Check out "Pick a Portfolio!" on Fool.com, and start building your portfolio. But first …

Action: Determine how much you should invest in stocks. Just use Bernstein's table above. And remember that our appetite for risk changes depending on current market and personal circumstances. So err on the conservative side if you're taking this quiz during a bull market (and vice versa).


Read/Post Comments (7) | Recommend This Article (291)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 22, 2010, at 1:01 AM, adastraperaspera wrote:

    I think you're right that one's willingness to lose a certain % of one's portfolio determines how much risk one takes.

    I think those that think the current market has a good chance of collapsing should recognize that the Fed has got a very close and anxious eye on the market and may do almost anything to keep it stable. My naivete may be exposed, but so be it.

  • Report this Comment On March 20, 2012, at 8:34 PM, Azrielnoir wrote:

    Things are definitely shaky but it is in times like these that some say the best opportunities are found.

  • Report this Comment On July 28, 2012, at 9:04 AM, Quiza23 wrote:

    Allocation has always had me mentally jumping from type of asset to another. Not good, this article seems to give a good perspective. Thanks.

  • Report this Comment On January 08, 2013, at 5:24 PM, aaronleetx wrote:

    HOW DO YOU BUY THINGS?!(if you have time can you please reply, PLEAAAAAAAAAAAASSSSSE!!!!!!!!!!!!!!!!)

  • Report this Comment On January 12, 2013, at 4:52 PM, NickD wrote:

    Online brokerage accounts to buy stocks

  • Report this Comment On February 18, 2013, at 6:34 PM, BillRamthun wrote:
  • Report this Comment On May 09, 2013, at 6:58 PM, Pumpbuster wrote:

    Annuity set up still looking for high paying divide paying stock for long haul.....

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