While it's impossible to accurately predict investment returns, especially over short periods of time, long-term returns of the stock and bond markets can be estimated by using historical trends. Therefore, we can estimate how a properly allocated investment portfolio could perform over the long run.
Here's a brief introduction to asset allocation and how this concept can help you build the retirement nest egg you need, without too much risk.
A rule of thumb for asset allocation
When we say "asset allocation," we're referring to how much of your portfolio should be invested in stocks (equities), bonds (fixed income) and cash-equivalent assets, like CDs. To be clear, there's no perfect rule for asset allocation, and while age is the primary factor that determines your ideal allocation, there are other things that could make your ideal asset mix higher or lower than a generic age-appropriate level.
As an example, if you're planning on paying your child's college tuition in a couple of years, you may want to keep more money in risk-free cash assets. On the other hand, if you have more-than-enough money to support a comfortable retirement and are still working, you may be comfortable taking more risk than most people your age.
As a baseline, a good starting point is to take your age and subtract it from 110 to find your approximate stock allocation. For example, I'm 35, so that means I should have roughly 75% of my portfolio in stocks. The remainder should generally be invested in fixed-income investments. I suggest that, for most people, keeping substantial amounts of investable assets in cash is a bad idea. I'm not talking about keeping an emergency fund -- that's a good reason to stockpile some cash assets. Rather, I'm saying that you shouldn't do things like invest half of your 401(k) in a money market fund.
The basic concept here is that stocks have historically outperformed other asset classes over long time periods. In fact, the market has historically averaged 9%-10% annualized returns. However, stocks are also more volatile than bonds, and are therefore less appropriate for investors who don't have long time horizons -- such as retirees.
Bonds, on the other hand, have historically produced lower (4%-5%) returns over time, but can also be relied upon to produce steady income, and to have less volatility than stocks.
To illustrate this concept, let's say that you're 30 years old and open an IRA. You deposit the maximum of $5,500 this year and continue to do so until you're 62, when you'd like to retire. In all, you will have contributed $176,000 to your IRA over this 32-year period.
Using our rule of 110, this means that, initially, your portfolio should be 80% allocated to stocks and 20% to bonds. And by the time you're 62, the rule says that you should have a 48%/52% mix of stocks and bonds.
Assuming that your stock investments average 9% total returns over the long run and your bond investments average 4%, your $176,000 in contributions would result in a $616,000 nest egg by the time you're 62. You would take advantage of the aggressive growth potential of stocks in your younger years, but once you're ready to retire, the majority of your portfolio will be made up of fixed-income assets, giving you a stable income stream in retirement.
How proper asset allocation could affect your long-term returns
Having said all of that, it can be quite a complex mathematical calculation to determine your theoretical returns year after year as you shift your asset allocation. Mathematically speaking, a properly allocated portfolio would have historically generated annualized returns of just over 7% throughout the average American's working years. So 7% is a reasonable rate of return to expect over long periods of time.
Here's a calculator that can help you determine your potential investment performance with a properly allocated portfolio. As I said, I suggest using 7%, but if you're planning to be more conservative or aggressive than most investors, this can be adjusted accordingly.
Editor's note: The following language is provided by CalcXML, which built the calculator below.