You have three main choices when it comes to investments in a brokerage account or retirement plan: stocks, bonds, or cash. There is no one-size-fits-all answer to the question of proper asset allocation, and your ideal mix depends on your age, risk tolerance, and time frame until retirement. Here's a guide to help you make the best decisions for the asset mix in your portfolio.
How much of your assets should be in stocks and bonds?
The answer to this question depends on a few factors. Most important is your age -- you should keep more of your assets in stocks while you're younger and have decades to ride out volatility and take advantage of the compounding power of stocks. As you get older, you should begin shifting some (but not all) of your assets into bonds, which are generally lower in volatility and produce consistent, reliable income.
As a general rule of thumb, subtract your age from the number 110 in order to determine your target stock allocation. For example, if you're 35, this rule says that approximately 75% of your assets should be in stocks.
Of course, some investors have a higher-than-average appetite for risk, while others place more emphasis on avoiding market fluctuations and preserving their capital. If you feel comfortable taking a little more risk in exchange for the potential of higher long-term returns, you may want to substitute 120 for 110 in the allocation formula, resulting in a higher stock exposure.
On the other hand, let's say that you're 55 and want to retire early. You have almost enough money to live a comfortable life in retirement, so your main goal is simply not to lose money. In this case, you can use 100, or even less, to determine the proper stock allocation for your age.
The point is that there's no simple answer. To further complicate matters, there is a wide variety of risk within stock investments. Speculative stocks and established blue-chip companies are two entirely different things, so we'll discuss that in more detail later on.
How much of your assets should be in cash?
The short answer: not much. A more thorough answer is that you should have a good amount of cash in a readily accessible place such as a savings account. Experts generally recommend that you aim to have six months' worth of your living expenses in a cash account, in order to be able to cover unforeseen expenses without tapping into your investments, borrowing the money, or selling something.
Provided that you have some sort of emergency fund, we think that 100% of your investment accounts should be in stocks and bonds. That's not to say you should take risks with all of your money -- there are certain types of bonds (short maturity and high quality) that aren't much riskier than cash and pay significantly higher interest rates than the average savings account.
It's important to mention that when we say "cash," we're referring to actual cash and similar investments such as money market accounts.
Having said all of this, if you need capital preservation (if you're already retired, for instance), it's completely fine to keep a small percentage of your investment assets in cash if you don't feel comfortable being fully invested in stocks and bonds.
What kind of stocks should you own?
When it comes to investing in stocks, whether you plan to choose individual stocks or buy mutual funds or ETFs, you have a lot to choose from. You can pick value stocks or growth stocks, large-, mid-, or small-cap stocks, international or domestic stocks, and stocks on all levels of the risk spectrum. Here are a few basic definitions you should know and then we'll discuss how you can figure out your stock allocation.
- Value stocks -- Companies with solid fundamentals that are perceived to trade at a discount to peers. A value mutual fund's objective is to identify and invest in a variety of undervalued stocks, with the goal of producing market-beating returns over time.
- Growth stocks -- Companies with faster-than-average growth as measured by revenue or earnings. A growth fund's objective is to identify and invest in the best growth stocks. Generally speaking, growth investing represents a higher level of risk than value investing.
- Large-cap stocks -- The exact definitions vary depending on whom you ask, but a large-cap stock is generally considered to be one with a market capitalization of $5 billion or more.
- Mid-cap stocks -- Companies with a market capitalization between $1 billion and $5 billion.
- Small-cap stocks -- Companies with a market capitalization less than $1 billion.
If you plan to invest in mutual funds, here are a few more definitions you should know:
- Index fund -- A fund that tracks an underlying index. As opposed to an actively managed fund, whose managers pick stocks with the goal of beating an index, an index fund simply buys all of the companies in the index in order to match its performance. For example, an S&P 500 index fund would buy the 500 stocks that make up the S&P 500 index.
- International fund -- A fund that invests in companies based outside of the U.S. This is not to be confused with a global fund, which invests in stocks from markets all around the world, including the United States.
If you decide to invest in individual stocks, it's a good idea to choose at least 15-20 stocks across a variety of sectors, and a few from each major category above (growth/value, large/mid/small). The majority of your holdings should be in larger, established companies, but diversification is the most important point.
Also on the concept of diversification, if you plan to invest in mutual funds, it's important to spread your money around. A broad index fund, such as one that tracks the S&P 500, is pretty diverse, but it's also a good idea to get some exposure to small caps and international stocks.
In a nutshell, there's no way for us to tell you exactly what your stock portfolio should look like, but as long as you diversify and stick mainly to stocks (or funds) that have a proven record of success, you should be just fine.
Bonds: Funds are the way to go (for most investors)
There are plenty of different choices when it comes to bonds. You can choose government bonds such as treasuries, municipal bonds, or corporate bonds. Within each of those categories, there is a wide variety of maturities to select from, ranging from a matter of days to 30 years or more. And there is a full range of credit ratings, depending on the strength of the bond's issuer.
Fortunately, for the majority of investors, a bond-based mutual fund or ETF is sufficient to meet their needs. Remember that the main reasons for allocating a portion of your portfolio to bonds are to offset the intrinsic volatility of stocks and produce a reliable stream of income -- not to produce long-term compound growth or beat the market. Therefore, a bond fund or two that fits your risk tolerance is really all you need. Vanguard's Total Bond Market Fund is one good example of a diversified, low-cost option.
Target-date retirement funds: Automatic asset allocation
No discussion of asset allocation would be complete without mentioning target-date retirement funds and whether they are good choices for your investment portfolio.
A target-date retirement fund (also known as a lifecycle fund) is a form of mutual fund that invests in a combination of stocks and bonds, gradually shifting its asset allocation from stocks to bonds as the target date approaches, and beyond. For instance, a target-date fund intended for people retiring in 2055 might have 90% of its assets in stocks and 10% in bonds, while a fund intended for 2020 retirees may have a 50-50 mix. The exact mix depends on the particular fund company, but the idea is the same.
At The Motley Fool, we're obviously in favor of choosing individual stocks, as long as you have the time and desire to properly research investments. Having said that, if you prefer a hands-off approach to investing and don't want to worry about shifting your asset allocation as you get older, a low-cost target date fund can be a good option. Here's a thorough discussion about target-date funds if you're interested.
The bottom line on asset allocation
While there is no one-size-fits-all asset allocation strategy, by analyzing your personal situation you can determine the best asset allocation for you. Doing so can get you the right combination of growth and income, while still allowing you to sleep at night.
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