Thrill rides are for amusement parks, not financial portfolios. Even if you love a good dose of heart-pounding action, wild swings in your account balances aren't the way to get it. When it comes to your wealth, keep things steady by following best practices for asset allocation.
Asset allocation is the diversification of your holdings across stocks, bonds, and cash. The goal is to balance the growth potential of stocks with the stability of bonds and cash for more predictable portfolio growth. There are many nuances to asset allocation, but we're boiling them down here to the top five, must-know rules.
1. Adjust your stock holdings according to your timeline
When your investment timeline is short, market corrections are especially problematic -- both emotionally and financially. Emotionally, your stress level spikes because you had plans to use that money and now some of it's gone. You might even get spooked and sell. And financially, selling your stocks at the bottom of the market locks in your losses and puts you at risk of missing the recovery.
Adjusting your stock allocation according to your timeline helps you bypass those problems. For example:
- You can go heavy on stocks if you're under 50 and saving for retirement. Your timeline is long, and you can ride out any market turbulence.
- As you reach your 50s, shoot for a blend of 60% stocks and 40% bonds. Adjust those numbers according to your risk tolerance. If risk makes you very nervous, for example, you'd decrease the stock percentage and increase the bond percentage.
- Once you're in retirement, you may prefer a more conservative allocation of 50% stocks and 50% bonds. Again, adjust this based on your risk tolerance.
- Any money you'll need within the next five years should be held in cash or investment-grade bonds with varying maturity dates.
- Keep your emergency fund entirely in cash. This is the ultimate in short investment timelines; you need this money available at a moment's notice.
2. Your tolerance for risk is more important than your age
You may have heard of age-based asset allocation guidelines like the Rule of 100 and the Rule of 110. The Rule of 100 determines the percentage of stocks to hold by subtracting your age from 100. If you are 60, for example, the Rule of 100 advises you to hold 40% of your portfolio in stocks. The Rule of 110 works the same way, but you start with 110 instead of 100.
These rules attempt to define your asset allocation solely by your investment timeline. The thing is, timeline isn't the only factor in play. Risk tolerance can be just as important. At the end of the day, diversifying your asset classes should provide you with peace of mind. If you're 65 and seasoned enough to stay cool through market cycles, go ahead and hold more stocks. If you're 25 and every market correction strikes fear into your heart, go with a 50/50 split between stocks and bonds. You won't have the highest returns on the block, but you will sleep better at night.
3. Market conditions never dictate your allocation strategy
When times are good, it's tempting to believe the stock market will continue to rise indefinitely. And that belief may encourage you to chase higher profits by holding more stocks. This is a mistake. You follow an asset allocation strategy precisely because you can't time the market and you don't know when a correction is coming. If you let market conditions influence your allocation strategy, you're really not following a strategy at all.
4. Diversify within asset classes
Diversifying across stocks, bonds, and cash is important, but you should also diversify within these asset classes. Here are some ways to do that:
- Stocks: Hold 20 or more individual stocks or invest in mutual funds. You can diversify your stock holdings by individual company and by sector. Utility companies, consumer staples, and healthcare companies tend to be more stable, while the technology and financial sectors are more reactive to economic cycles. Mutual funds are already diversified, which makes them a nice option when you are working with smaller dollar amounts.
- Bonds: You can diversify your bond holdings with bond funds. Or, you can vary your holdings across bond maturities, sectors, and types -- primarily municipal, corporate, and government.
- Cash: Cash doesn't lose value the way a stock or bond can, so diversification isn't a priority. If you have lots of cash, you might hold it in separate banks so all of it is FDIC-insured. The FDIC limit is $250,000 per depositor, per bank. But most people aren't sitting on that much cash. More realistically, you might diversify your cash to maximize your liquidity and interest earnings. For example, you could hold some cash in a liquid savings account and the rest in a less liquid CD with a higher interest rate.
5. Target-date funds manage allocation for you (sort of)
If you're nodding off just reading about asset allocation, there is another option. You could invest in a target-date fund, which manages asset allocation for you. A target-date fund is a mutual fund that holds different asset classes and gradually moves to a more conservative allocation as the target date approaches. The target date is referenced in the fund's name and refers to the year you plan to retire. A 2055 fund, for example, is built for folks who plan to retire in 2055.
Target-date funds do follow most of our must-know rules. They're diversified across and between asset classes, and the allocation is based on investment timeline. These funds are also simple to manage. You don't have to rebalance your portfolio or even hold any other assets, besides your emergency fund cash.
But there are drawbacks. Target-date funds don't address your personal risk tolerance or the possibility that your circumstances may change. You might get a big promotion that enables you to retire five years earlier, for example. In that case, you'd want to review the allocations in your fund and decide if they still make sense for you.
Make your own rules, too
No single approach to asset allocation addresses every situation perfectly. Lean on your risk tolerance and your investment timeline to land on an approach that works for you. Or, you can wing it -- but make sure your seat belt is buckled, because it might be a wild ride.