Asset allocation is a simple concept. By spreading your investments across a range of different categories, you can help to enhance your overall portfolio return while adding diversification that will hopefully smooth out some of the bumps in the financial markets along the way. In simplest terms, by having a reasonable mix of bonds and cash among your investments, you can afford to take the risks involved with stocks. Similarly, with blue-chip holdings like PepsiCo (NYSE:PEP) and Procter & Gamble (NYSE:PG) composing a significant part of your stock allocation, you can afford to take bigger risks on smaller stocks like Pegasystems (NASDAQ:PEGA).
However, many asset-allocation strategies leave out one thing: your particular financial situation. People commonly use a number of tools to match their risk tolerance to a particular allocation strategy. There are also common rules of thumb that help people calculate asset allocations, based on factors such as age. Some mutual funds that use asset allocation strategies, such as the Vanguard Target Retirement Funds, actually adjust their asset allocations automatically over time to reflect the length of time remaining until a specified future date. Yet most of these tools pay little attention to your goals, and how much money you'll need to reach them. Without tailoring an asset allocation to your own individual situation, you'll lose much of the value of such strategies.
Are you already there?
Time after time, various people who have already retired tell the same story about interesting conversations with their brokers or other financial professionals. In some cases, retirees with extremely conservative portfolios are urged to move some of their money into the stock market. Conversely, some retirees who have been successful with stocks are advised to trade them for more conservative investments. Many of these professionals will point to the rules of thumb that dictate that older investors should reduce the amount of risk they are taking with their portfolios.
However, focusing solely on rules of thumb is shallow and simplistic. The appropriateness of an investor's particular asset allocation depends on what that investor is trying to achieve. For example, if a retired couple of modest needs has a $10 million nest egg, it's quite likely that investing all of their money in risk-free securities like Treasury bills or insured bank CDs is perfectly adequate for their limited needs. However, if this same couple is more interested in maximizing their heirs' financial legacy, a substantial stock allocation would likely help build up assets more quickly. Since they need relatively little for themselves, they don't have to worry about losing money in the stock market; from their perspective, a down market could be a temporary blip for their family fortune, even if they didn't survive to see the market rebound. Relying solely on popular wisdom can put you in the wrong strategy for your particular goals.
... Or are you way behind?
Tools can be somewhat helpful in measuring your progress toward your goals. Once you've established how much money you need, and when you'll need it, you have control over only two variables: How much you can save, and what rate of return you want on your money. Even though you can't be certain about achieving any particular total return target, the figure you choose should give you a general idea about how much risk you need to take in your portfolio.
For instance, say that you're 55 years old and have determined that you need $1 million in retirement assets by the time you turn 65. You've already saved $300,000 in retirement accounts, and you can contribute an additional $1,000 each month over the next 10 years. Using the Fool's trusty millionaire calculator, you can calculate that you'll need to achieve an average annual return of 9.81% from now until retirement in order to get to your $1 million goal. That means you'll probably need a relatively high amount of risky investments like stocks or junk bonds in your asset allocation; expecting high-quality fixed-income securities to produce 10% returns is not very realistic.
On the other hand, if in the same situation you had already put $500,000 toward your goals, you'd be in a much different situation. The millionaire calculator now says that you only need an average return of 5.23% to get to the $1 million mark. As a result, you may not need to invest in stocks at all to get there; instead, you may be able to find long-term CDs and bonds that can provide you with enough income to reach your goals.
Of course, the real challenge is knowing how much you'll actually require to meet your financial needs. Because it's almost impossible to guard against every risk you face, including inflation, unanticipated expenses, and higher tax rates, erring on the side of a bit more risk and a slightly higher return may be more prudent than simply hoping for the best.
Asset allocation strategies hold the promise of easy-to-follow guidelines that simplify the work of investing. Only by looking at your own particular resources and needs, however, can you come up with an asset allocation strategy that will truly work for you.
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Asset allocation is a big part of creating a portfolio for retirement, but it's not the only part. For more on this and other important topics about your retirement, take a look at the Motley Fool's Rule Your Retirement service. Fool expert Robert Brokamp provides helpful information in an easy-to-read format. You can see for yourself with a 30-day trial.
In his quest for financial independence, Fool contributor Dan Caplinger is always looking for more. He doesn't own shares of the companies mentioned in this article. The Fool's disclosure policy gives you just what you need.
