4 Rules for Asset Allocation

It's one of the biggest questions in investing: "How do I divide up my money between all the different kinds of investments out there?" There are stocks, bonds, and real estate. Gold, pork bellies, and even mayonnaise jars. What to do?

Robert Brokamp, author of the Motley Fool Rule Your Retirement newsletter service, has some simple advice that nearly everyone can follow:

Rule No. 1: If you need the money in the next year, it should be in an interest-bearing savings or money market account.
It's extremely hard to predict short-term movements, especially in the stock market. For instance, let's say you own Cisco Systems (NASDAQ:CSCO) or ExxonMobil. You may be confident that these stalwarts are sound long-term investments. But it would be irresponsible to "invest" money in them if you'll need that money for next month's rent or your kid's tuition next year. Why? Well, in the past five years, each of these has dipped 25% or more in a period of months at some point.

When even seemingly solid companies like Oracle (NASDAQ:ORCL) can lose 30% to 50% over a short period of time, it's not really investing -- it's gambling.

Rule No. 2: If you need the money in the next one to five (or even seven) years, choose safe, income-producing investments such as Treasuries, certificates of deposit (CDs), or bonds.
Now, with a little more time on our hands, we'll move slightly up the risk ladder. In order of "safest" to "still safe but technically riskier," we have Treasury notes and bills, CDs, and corporate bonds -- each providing a bit higher yield than the one before it.

Rule No. 3: Any money you don't need for more than seven years is a candidate for the stock market.
We believe the stock market is the best choice for your long-term money, and so does Jeremy Siegel. As he explains in Stocks for the Long Run, not only have stocks easily outperformed bonds over the past 100-plus years, they've also beaten bonds in 80% of all rolling five-year investing periods since 1802 (i.e., 1802-1807, 1803-1808, etc.). Stocks also won in 90% of all rolling 10-year periods, and essentially 100% of all rolling 30-year periods.

To further illustrate the power of time on good companies, here are four stocks that dropped at least 30% in the past seven years, along with their seven-year total return:

Rule No. 4: Always own stocks.
Even if you're at or near retirement age, stocks can help your portfolio beat the debilitating effects of inflation. Sure, at that point you'll have plenty of short-term money in safer Treasuries or CDs. But these days, the average 55-year-old still has another quarter-century of life ahead of her!

But ... which stocks?
There's still much to consider, including which money market accounts, bonds, CDs, and stocks are best for you. We have a free report called Perfect Your Portfolio With Asset Allocation that gives specific recommendations in each of these categories. It's available to anyone taking a free trial to Rule Your Retirement.

This article was originally published Jan. 11, 2006. It has been updated.

Rex Moore has 0.00014% of his portfolio in baseball cards. He does not own shares of any company mentioned. The Fool's disclosure policy sponsored this message.