Choosing your asset-allocation model is one of the most important decisions you make as an investor. The combination of stocks, bonds, and cash that you pick is a major driver of what your portfolio's returns will be.
But many people don't know how to figure out the best asset-allocation model for them. Here's how to make sure you pick the right one.
1. Define your goals
Once you define your investment objectives, you're in a position to choose your asset-allocation model. Setting goals can make you more successful at attaining them, according to a study from the Dominican University of California. In this study, which included 149 participants, those who did simple things like writing specific, realistic, and attainable tasks achieved them more often than those who did not.
When you set a goal, it's more likely that you'll commit to reaching it and hold yourself accountable if and when you miss your mark. You should have an overall objective for your portfolio, as well as each of your accounts. Are you saving for your child's education or your future retirement? Buying a new home or building an emergency fund?
After you've decided what you're saving for, you can get more targeted. What type of account will you use? How much should you save and how can you best budget for your saving?
2. Assess your risk tolerance
Do the ups and downs of the stock market make you panic? Does your stomach drop every time there's a correction? How you answer these questions will help decide your risk tolerance, which is a big factor in how well you can stay invested over the long term.
If you take on too much risk, staying invested in volatile markets could be hard. You might find that when the market crashes, you sell your investments and only feel good about buying back in when they've rebounded. Between 1993 and 2018, the S&P 500 had an average annual return of 9.1%. The average investor over that same period of time had a return of 6.8%. This happens because emotions get in the way and can control your decisions.
If the opposite is true and you're invested too conservatively, though, you might have lackluster returns. Market volatility won't be an issue for you, but your investments may struggle to keep pace with your investment goals.
There are some guidelines on how to come up with an asset allocation between bonds and stocks. A popular one, the Rule of 100, tells you to subtract your age from 100, and the number left over is the percentage of your portfolio you should invest in stocks. The remainder would be divided between bonds and cash.
The amount of risk you take on is unique to you, though, and rules of thumb like this don't always properly address your comfort level. You can get a better idea of your personalized risk tolerance by taking a quiz that will take your individual circumstances into consideration.
3. Pick a time horizon
After you define your goals, set up a time frame for reaching them. Point B is your goal -- where you ultimately will end up -- and point A is where you are now. Your time horizon is the distance between the beginning and end of your journey.
Your time horizon might already be defined for you. If you're saving for the college education of your newborn, you know exactly how much time you have before needing your money. Your time horizon might depend on how quickly you can save money toward your goal. If you're saving for retirement, you may only retire once you've saved a certain dollar amount -- even if it means working longer.
When you have a long time horizon -- five years or longer -- higher stock allocations will likely improve long-term returns. But if you have a shorter time horizon, the volatility in stocks can make other types of assets more appropriate for saving. You don't want to hold stocks for a short-term goal, only to run into a year like 2008, in which the S&P 500 fell 37%. That kind of short-term loss would likely keep you from reaching your goal on time.
Be smart about asset allocation
Your asset-allocation model determines how much of each investment class you hold, but it's responsible for far more than that. It could affect how successful you are at saving enough for important life events.
Getting it right will take some thought, and you might even find that it occasionally needs adjustments. The time and energy that you put into it will be well worth it, though, if it puts you on the right track for meeting your goals.