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Fool's Rules for Asset Allocation

When it comes to asset allocation, the biggest decisions come 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. If you're looking for the best yield, check out such national, Net-savvy banks as Virtual Bank and ING Direct. And, of course, make sure it's FDIC-insured.

Rule 2: If you need the money in the next one to five (or even seven) 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-yielding. CDs are still very safe (as long as they're FDIC insured), can usually be bought commission-free, and you should be able to find some that pay a percentage point above Treasuries. Shop around for the best rates; your local bank may not be the best-yielding option.

As for corporate bonds, the general rule is to choose bond mutual funds if you have less than $25,000 to $50,000 to invest. That's because buying individual bonds can be tricky. With a stock, you can pull up a quote on your computer and -- presto! -- you have a good idea of the going price. However, most bonds don't trade on a centralized exchange. And instead of charging a commission, most brokerages (discount and full-service) embed a "markup" in the price of the bond. This makes it difficult to know what fees you paid.

It is gradually becoming easier (and more cost-effective) to buy individual bonds, so it can be done if you're willing to put in the effort. The advantage of individual bonds over bond funds is you know exactly how much you'll get back when the bond matures. However, since bond funds don't technically "mature," you don't know what your investment will be worth when you need the money. In fact, they can lose quite a bit of money, which can be inconvenient if it happens right before you need it.

If you're going to choose a bond fund, stick with short- to intermediate-term bonds (i.e., bonds that mature in two to five years). 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 for more than five to seven years is a candidate for the stock market.
We Fools are fans of the stock market, and we know our history. According to Ibbotson, large-cap stocks, on average, have returned 10.4% annually from 1926 to 2007, compared to 5.5% for long-term government bonds and 3.7% for short-term Treasury bills.

However, investors in stocks have to keep that "long run" part in mind, since in the short run, no one knows what stocks will do. 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 Center for Disease Control, a 55-year-old can expect to live another 26 years. A 65-year-old has another two decades. 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.

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 vehicles to ensure your portfolio withstands inflation and your retirement spending.

According to Jeremy Siegel's Stocks for the Long Run, for every rolling five-year investing period since 1802 (i.e., 1802-1807, 1803-1808, etc.), stocks outperformed bonds 71% of the time. Stocks beat bonds in 80% of the rolling 10-year periods, and essentially 100% of the rolling 30-year periods. 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.


Read/Post Comments (17) | Recommend This Article (180)

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 March 28, 2010, at 8:53 PM, ITAWealth wrote:

    "Over the long term, equities are the best vehicles to ensure your portfolio withstands inflation and your retirement spending."

    A counter argument to the above statement comes from Zvi Bodie. Here is an interesting article that presents both Siegel and Bodie's positions.

    ITAWealth

    http://www.advisorperspectives.com/newsletters09/The_Retirem...

  • Report this Comment On June 15, 2010, at 5:17 PM, dennisg65 wrote:

    Most brokerage houses have in common the promotion of "proper asset management". I have found through experience this is at best over estimated, and at worse just wrong.

    In fact, "appropriate sector management", combined with solid, well researched companies within the sectors, work the best. For this investor, annual ROI's have had nothing to do with size of the assett.

    A mix of proper equities (for me solid fundamentals, fair values, reasonably safe dividends, great management, niche products etc.) have produced annual double digit returns. It's a disciplined approach that counts.

    Just ask Buffett.

  • Report this Comment On July 08, 2010, at 6:19 PM, mrjenny wrote:

    This is so obvious its nuts. If you have the money to follow these rules, your already are well off most likely and if your not you may not want to leave the stocks or even one stock, It all a matter of concentration and regulation of ones faith in a stock.

    So if your guys want to be super conservative and responsible fine. Oh and there is nothing easier to ambush than homes in the middle of nowhere. You would be safer in NYC in a high rise apartment. and anyone who is planning a civil war best stop, because prognostication leeds to impulsive action and fosters the exact environment its trying avoid, civil unrest.

  • Report this Comment On July 08, 2010, at 6:21 PM, mrjenny wrote:

    you can't plan for disaster. fate will trump you I am sure

  • Report this Comment On July 16, 2010, at 7:41 PM, jcohen11 wrote:

    I agree that proper asset allocation is the most important factor to ensure long term success. But I may add that this is only the first step, it is not sufficient to have a long term buy and hold portfolio and then do buy and forget in the current and coming economic cycles.

    It is a fallacy to use 'long term' better return and extrapolate to any given time. For an average investor, 5 or 10 years are very long term. Furthermore, we can't simply ignore the current situation and then just apply 'long term' portfolio blindly.

    A few quotes to chew on:

    'In the long run we are all dead' Keynes

    'The new normal' PIMCO's assessment of the coming 5 to 10 years

    It is also critical to have a discipline to implement the asset allocation. For buy and hold and rebalance type, you might want to check out

    www.marketriders.com

    www.noloadfundinvestor.com

    www.myplaniq.com (their strategic asset allocation is free).

    For actively managing your asset allocation (or tactical or dynamic asset allocation), check out

    www.myplaniq.com. This is by far the most impressive service/system I have seen.

    I hope fool one day can move a step further in this direction. We people really need this.

  • Report this Comment On November 26, 2010, at 7:59 PM, masservices wrote:

    Excellent, practical and focused info.

    Warning! as we age we always think we are much younger that we are chronologically. That's why we see so many 80 year old's in short shorts and halter tops.

    Dress and invest age appropriately.

  • Report this Comment On June 24, 2011, at 12:22 PM, secretbonus wrote:

    There is bias in "stocks for the long term" because there are many delistings, and many stocks that go to zero that don't reflect the risk when tracking the S&P or any index.

    The last 150 years stocks have only beat inflation by 2% with a 6-7% return.

    I believe the correct way to play would be as Ben Graham describes in the intelligent investor on his chapter on the defensive investor. You have bonds and stocks no more than 75% of either, the defensive investor would always have 50/50... and you rebalance. If stocks go up so your balance is 55% 45% you raise 5% cash from stocks and add it to the bonds. I think you also should have a very small amount in gold to hedge against lack of good government money management, fears of default and hyperinflation.

  • Report this Comment On November 09, 2011, at 2:25 PM, jac102 wrote:

    Hmm, So rule 1,2,3 or 4? and considering the MDP way.

    My wife and I are about 3 years into retirement. Our S.S. and Medicare + some private health have been working . Their is a modest retirement contribution.

    It's said we have about 20 years to go. Is this the best and safest way for me to go. MDP is 5.6% down.

    jac102

  • Report this Comment On January 16, 2012, at 1:20 PM, rma1344 wrote:

    Ironically, the best investment I ever had was in my employer's stock and options. It was GE, which was a diversified company, run by Jack Welch who was a portfolio manager. He continuously managed and pruned the portfolio to ensure he had winners. He had some losers but they were not big enough to offset the winners. He also was lucky to have run GE during a bull market. Bottom line is diversification is important but luck comes into play also!!

  • Report this Comment On November 01, 2012, at 12:09 PM, batman9999 wrote:

    "According to Ibbotson, large-cap stocks, on average, have returned 10.4% annually from 1926 to 2007, compared to 5.5% for long-term government bonds and 3.7% for short-term Treasury bills."

    This article was written late in 2012. Why not show the annual return through 2011? Yes, the numbers for those years will take down the average but it provides a more accurate reflection of stock market performance.

    If you're going to cherry pick the years, then you might as well exclude the crash of 1929 too.

  • Report this Comment On November 22, 2012, at 12:26 PM, aleax wrote:

    @secretbonus, you say "There is bias in "stocks for the long term" because there are many delistings, and many stocks that go to zero that don't reflect the risk when tracking the S&P or any index.". Read Siegel's "The future for investors" (his second book after "stocks for the long run"): he starts with the 500 stocks that were in the first S&P500 index in 1955 and tracks them in detail for 50 years through all of their vicissitudes (mergers, acquisitions, spin-offs, bankruptcies, ...) reinvesting every dividend. (I think he can do it only because as a university prof he can use very cheap graduate-student labor;-). I.e essentially a no-trading strategy (except for the dividend reinvestment and the investment of cash you receive when one of your companies is acquired or goes private). The results are just wonderful, much better than tracking the S&P500 as it slowly changes most every year. This logically dispels your fear of survivorship bias in LTBH investing (in reasonably large-cap firms).

    That being said, I do like Ben Graham's "simple asset class allocation and (not too frequent!) rebalancing" idea -- it enforces value investing because you're always buying low and selling high, esp. when paired with DCA and automatic dividend reinvesting (ideally commission-free DRIP).

  • Report this Comment On March 06, 2013, at 2:12 AM, pankajjain wrote:

    Points 3 and 4 are completely relevant which most of investors like me miss out on.

  • Report this Comment On April 06, 2014, at 5:59 PM, ggjungle1 wrote:

    Does anyone kown about Stansberry research comment that stocks and bons are going fall apart with a new law that will be signed in July 1. I do not remember the law #. It has somthing to do with the dollar not being used all over the world.

  • Report this Comment On May 15, 2014, at 10:22 PM, chaomeow wrote:

    i saw that report too. Don't know what to do. Cause I am new to investment myself. Wonder what will David and Tom will say?

  • Report this Comment On June 22, 2014, at 9:08 AM, Blackhawk wrote:
  • Report this Comment On June 30, 2014, at 1:53 PM, LAVol wrote:

    I'm 62, no debt, with sufficient income (consulting, deferred income, rental property, dividends, pensions, soc. sec.) to live comfortably for the rest of my life. I have a significant stock portfolio, with almost ⅓ of the portfolio in AAPL, cost basis is less than $9. Should I diversify away from AAPL or let it continue to run?

  • Report this Comment On November 25, 2014, at 9:15 AM, 67comet wrote:

    Let it run!

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