The 5-Minute Guide to Allocating Your Assets

Small-cap stocks are awesome, because they offer the unique potential to grow hundreds of times over -- something a behemoth like Johnson and Johnson just can't do from here. International stocks are alluring, not just because they're exotic, but also because they offer diversification against domestic stocks. But a portfolio consisting exclusively of small caps or international stocks is likely a recipe for disaster, while a portfolio of nothing but domestic large-caps might forgo the opportunity for higher returns.

Faced with this conundrum, what should you do? There are as many asset allocation strategies as there are Fools, but generally speaking, you're looking for a blend of stocks (and bonds and REITs) that will serve you well in varying market conditions. They'll give you opportunity for tantalizing growth without forcing your kids to grow up with crooked teeth because you lost the money for their braces.

For specific examples, our Rule Your Retirement team created these three model portfolios, which you can use as a starting point for cooking your own investment soup. We've described each one after the following table. (Please note that we excluded cash from these allocations. We're assuming you have the money you need in the next year, as well as an emergency fund, already sitting safely in a money market account or similar investment.)

Large-cap stocks
Because they are generally less volatile, large-cap stocks should make up the bulk of a retiree's or near-retiree's stock portfolio. Big, international companies such as McDonald's, General Electric, or Procter & Gamble have been around for a long time, and they'll likely continue to be among the world's strongest companies for quite a while.

Small-cap stocks
These are the up-and-comers, or the companies with niche products or services. They may fly under Wall Street's radar, but once they're discovered, they take off. This is one of the reasons small-cap stocks outperform large-cap stocks by a percentage point or so over the long term. However, their prices are also prone to wider swings, including total loss scenarios. For this reason, they're considered riskier, and they should make up a smaller percentage of your portfolio.

International stocks
Though the U.S. stock market is by far the biggest in the world, it is just one of many -- and it's not always the place for the best returns. For the three years prior to the launch of Rule Your Retirement (2004), the return of the Vanguard Total Stock Market Index Fund, which mirrors the performance of the entire U.S. stock market, lost an average 0.62% a year. However, the Vanguard Total International Stock Index Fund returned an average annual return of 2.37% over the same period.

For diversification purposes, it makes sense to have some money in other markets. Now, some Fools think they get plenty of international exposure by investing in American multinationals such as Coca-Cola, which derive much (if not most) of their revenue from abroad. Fair enough. It all comes down to how much risk you want to take (international stocks are more volatile, come with a bevy of country-specific concerns, and are generally held to fewer regulatory standards than domestic stocks) and how many assets you want to manage.

Real estate investment trusts (REITs)
In the language of asset allocation, you're looking for assets that are not highly correlated -- i.e., assets that don't move in sync. You're not getting much diversification if all your assets generally move up and down at the same time. Herein lies the value of REITs: the latest financial crisis notwithstanding, they are not usually highly correlated to stocks or bonds. They move, at least partially, to the beat of their own drum. Also, because REITs must pay out 90% of their earnings to receive favorable tax treatment, they pay nice dividends (though those dividends are not eligible for favorable tax treatment on your tax return, unlike dividends from most other stocks).

Bonds
A bond is an IOU. You're lending the government or a corporation money, and they promise to pay you back with interest. Bonds won't make you super-wealthy, but you won't lose your shirt, either. Studies show that you're better off sticking with short to intermediate maturities (two to five years). You could also parse your bond portfolio, creating a mix of safety (U.S. government and municipal bonds) and higher return (corporate and even "high-yield," aka junk, bonds). It all depends on the amount of risk you want to take, and the amount of time you want to spend on it.

Others
You could partition your portfolio into more categories, such as emerging-market bonds and mid-cap stocks. Those are worth considering for the actively engaged investor, but the breakdowns offered above will get you most of the way there. The only additional differentiations we'd like to consider here are the following:

• Value vs. growth: These styles take turns outperforming each other in particular years, but for the long term, go for value. Lower-P/E stocks are less volatile and provide a margin of safety. Plus, they're more likely to pay...
• Dividends: They're the proverbial bird in the hand, so look for them when possible. Plus, if you're retired and relying on your portfolio, dividends reduce your need to sell assets to provide income.

For more on asset allocation and all things retirement planning, visit our Rule Your Retirement service.