DES PLAINES, IL (Nov. 9, 1999) -- A question that often comes up in the Workshop, especially when the market gets volatile, is: "How much of my portfolio should be in stocks?"
The answer, of course, depends on your life and your risk tolerance, but there are some rough guidelines you can use.
First of all, as mentioned in Step 2 of the 13 Steps to Investing Foolishly, you should pay off all high-interest debt and develop the habit of saving a little (or a lot!) from each paycheck before you even start thinking about stocks. Once that's done, it's time to start thinking about where to put that savings. Generally, your investments can go into one of three "buckets."
Bucket A is an emergency fund, which is cash set aside in a money market account or similar safe, instantly accessible place for... well, for an emergency (you lose your job, your septic tank explodes, statisticians hurl grapefruit through your front window, etc.).
Bucket B represents savings that you will need within the next three to five years for extraordinary, but foreseeable, expenses. For example, saving for a down payment on a home, kids going to college, your next car, that mountain chalet, etc.
Bucket C is long-term savings (money you won't need for at least three years, preferably much longer). Historically, the best place to put money long-term has been the U.S. stock market. You don't have to put all your Bucket C money in the market, but not doing so is likely to cost you money down the road.
The amounts you have in each "bucket" will change as your life changes. If you're fresh out of school, your emergency fund may consist of a case of instant ramen noodles, canned goods (soup, tuna, and -- my personal favorite -- cold, canned pasta), and the possibility of moving back in with Mom and Dad. After you get married and have kids, your emergency fund will probably consist of cash to cover anywhere from one to six months of expenses, depending on how stable your career is. With kids, many people will enlarge Bucket B in preparation for college.
As you approach retirement, you should shift some of your long-term savings into the A and B buckets to cover expenses after you stop working. Just remember that with any luck, you'll live for a number of years after retiring.
Also remember that 401(k)s and IRAs offer an excellent opportunity to save Bucket C money tax-deferred (or tax-free in a Roth IRA). As we've discussed the last few weeks, taxes are a huge drag on investment returns. If Uncle Sam offers an opportunity to save tax-free, just say yes! And if your employer matches 401(k) contributions, even better. Can you say "free money"?
Now, what was missing from the above? That's right, NOWHERE did we mention current performance of the market! Foolish investors don't care how current P/Es compare to historical numbers, or whether the Fed will raise interest rates. Nor do we have any magic formulas of 60% stocks/35% bonds/5% cash or other nonsense. Foolish investors don't let the market run their lives, they make sure that their lives are running their investments!
Once you start looking at your investments this way, it gets easier to think long term and weather the ups and downs of the market. Rather than saying, "The market's down, what should I do with my portfolio," you'll say, "Looks like we'll be needing a new car in a year or two, what should I do?"
Here in the Workshop, we're looking at ways to invest Bucket C money -- and ONLY Bucket C money -- through mechanical stock screens. We can't guarantee that we'll beat the market, but we're trying to be disciplined and rational in testing our methods and quantifying our results. If this appeals to you, come and visit the Workshop message board for more information and ideas.
We'll talk a bit more about being disciplined and rational next week. Until then, Fool on!