One of the first things you should do before investing is deciding what percentage of your accounts will be divided between stocks, bonds, and cash. Choosing your asset allocation is a crucial step, and this one move is a major factor in how your accounts will perform.
This rate of return could determine how quickly you can meet your goal and with how much money. It can be chosen by using one of these three methods.
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Age-based
When you choose an age-based asset allocation model, you are decreasing the percentage of stock that you own as you get older. You can apply this method by subtracting your age from either 100 or 110 and the number that you come up with is the percentage of stock that you should own. So, if you are 40, you would hold 60% stock and 40% bonds if you use the number 100 as your baseline or 70% stocks and 30% bonds if you use 110.
Choosing your mix of stocks, bonds, and cash this way is easy. Anyone can quickly calculate it without fancy tools, which makes it popular. But it is limited in that it probably only works best for a goal such as retirement. And even with retirement, it assumes that everyone will retire around the same age, instead of across a range of, say, 62 to 70.
Goal-based
If you have another goal like saving for a home or college, the age-based method doesn't work as well. And instead, you could choose your allocation based on when you will use your money -- where your time horizon is the driving force behind how aggressively you invest.
This type of asset allocation model can work with almost any objective, no matter how short or long. The premise behind it is that you don't want the money that you will be using soon invested too aggressively. If you do, a stock market crash could cut your balance significantly and prevent you from reaching your goal. But this model doesn't have as much guidance for how much stock you should own, just the recommendation that the shorter your time period is, the more conservative your holdings should be. The longer the time period until your goal, the more stock you can own.
Personalized approach
But these two methods leave out important information about how you feel about volatility and how you've reacted to it in the past. That's why taking a simple quiz that will personalize your asset allocation model may be a better approach. This type of process will take into account things like your age and when you will use your money as well as your appetite for risk. It will also consider things like your income and whether or not you have an emergency fund, which could play a huge role in your liquidity needs.
After taking this quiz, you'll get an asset allocation model that ranges all the way from conservative to aggressive. An example of a conservative portfolio is one that holds mostly cash and bonds with a small portion allocated to stock, but probably no more than 15%. A moderate portfolio will still hold mostly bonds and cash but more stock than a conservative model. While a balanced portfolio will be evenly split between bonds and stocks. If you are a growth investor, your allocations will now be more skewed toward stock, and if you are the most aggressive of investors, you will hold no bonds or cash, only stock.
The more stock you own, the higher your average rate of return will be, but so will the amount of money you stand to gain or lose in a given year. For example, if you owned a portfolio of only large-cap stocks between the years 1926 and 2020, your average rate of return would've been 10.2%. Your worst year of performance would've resulted in a 43.1% loss and your best year would've gotten you a 54.2% gain. Instead, if you'd owned a portfolio made up of 30% stocks and 70% bonds, you would've had an average rate of return of 7.7%. Your worst year would've lost you 14.2% and your best year would've earned you 38.3%. If the thought of losing money terrifies you and you find yourself selling out of your investments so that you can avoid this fate, how old you are and your time horizon don't matter as much. And a more conservative model with a lower average rate of return but also less downside risk may help you stay invested more consistently.
Choosing an asset allocation model is a very important first step. And doing so will provide you with direction on how you can best meet your goals rather than guessing at it. The more you tailor this process to you, the more it may help you accumulate wealth over the long term.
