Have you ever heard a rule of thumb such as "investors should keep a third of their investments in stocks, a third in bonds and a third in cash"? If so, then you've run across the concept of asset allocation, or portfolio allocation.
There are many allocation formulas out there, and some Wall Street brokerages make headlines and incite the market when they announce changes to their recommended mix of stocks, bonds, and cash. We chuckle when financial advisers announce they're changing their ideal portfolio mix from something like 47% stocks to 49% stocks. Such tweaking seems utterly un-Foolish -- and somewhat self-serving, too, to the financial industry. After all, for portfolios to be continually adjusted means that various holdings will continually be sold and bought, generating commissions (and often, capital gains taxes to be paid).
Our basic guidelines follow investment time frames -- and, of course, what you can tolerate in terms of market volatility. In general, money that you don't expect to need for five years (ideally 10 years or longer) might be invested 100% in stocks. Stocks can be volatile in the short term, but they have performed well in the long term over many time periods.
Note that investing in stocks can simply mean that you buy shares of an index fund that tracks the overall stock market. It doesn't mean you have to become an expert stock analyst. An index fund can immediately have you invested in shares of companies such as General Electric
Any funds that you'll need to use in the near future -- such as your emergency fund or a down payment for a new home -- should be in something safe, such as certificates of deposit, money market funds, or perhaps bonds. (We offer many tips on short-term savings and some good deals in our Savings Center.) Whatever's left over is likely to grow most quickly in stocks.
However, not everyone agrees with this advice. Here's what a couple of respected Fool Community members had to say about our stance on asset allocation:
Yeah, the market performed a little better than cash and fixed instruments six decades out of the past seven. That is no guarantee of its performance in the next seven, and especially for the next two, or for that matter, for the rest of your life. And the indices are even composed of stocks that rotate in and out of the index all the time. The barometer is rigged for success. If you aren't moving money around from year to year, a more true gauge of the blind market over time for you would be one that kept the same companies, bankruptcies and all, in the same index. But those kinds of indices would look like [$%^@#], so nobody in financial services wants to keep one for you. Worse, if your stock is an individual one and you never move it at all, you've got a 33% chance of losing money over the next 10 years. Are you sure you want to take that chance with 100% of your money? Please be sensible and put at least a quarter of it in bonds and cash, regardless of your age, and at least a third of it if you're middle aged. -- jeanpaulsartre
The Motley Fool is rather spotty on asset allocation in general. This despite the fact that academia suggests that asset allocation is the most important factor in determining long-term investment returns -- far more important than one's choice of investments within a given asset class.... As long as there is risk to an investment, many (if not most) investors will be better off with an asset allocation that addresses, rather than ignores, that risk. There is risk to a long-term holding of a broad-market index of U.S. equities -- and that risk doesn't disappear simply because the outcome hasn't manifested in a hundred years. Therefore, it is inappropriate to continue to suggest that the typical investor is better off being 100% invested in U.S. equities for long-term time frames. -- Albaby1
Good points, to be sure. Ultimately, asset allocation is about risk -- the old "don't put all your eggs in one basket" (as Fool Rex Moore explains in Talking Risk and Diversification). Investing in the stock market -- even an index fund -- isn't a sure bet. So ask yourself these two questions:
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How willing are you to risk that your money won't be there when you need it, in the hopes of having much more money down the road?
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How have you been able to stomach the bear market of the past few years?
Your answers to those questions should help determine how you should divvy up your dollars.
For more Foolishness, visit our Personal Finance area, our Investing Basics area, and our Fool's School. You can also learn a lot via our acclaimed How-to Guides and online seminars and our book, The Motley Fool Money Guide: Answers to Your Questions About Saving, Spending and Investing .
