Allocating your money across different types of assets is a proven strategy to help you invest smarter. But in order to make the most of that strategy, you'll want to follow asset allocation models that are tailored for your particular situation.
All too often, financial advisors suggest age-based asset allocations that rely on a number of assumptions about the financial situations of typical people in a particular age group. But unless your personal situation matches that average, blindly following an allocation won't give you the best results. Instead, you need to adjust your asset allocation to take into account where you stand and where you want to end up.
Know your starting point and your finish line
Basic asset allocation strategies tend to follow a few simple concepts:
- When you're young, it makes sense to take an aggressive approach, because you have a long time horizon and therefore can afford to take a lot of risk. As a result, asset allocations should gravitate toward riskier assets like stocks.
- As you get older, you have less time before you'll need to take money out of your portfolio to pay for living expenses in retirement. Therefore, most advisors recommend reducing your risk level in order to avoid losses and guarantee a stable nest egg from which you can draw income to cover your financial needs.
Yet while these ideas make a reasonable baseline, you shouldn't just stop there, because they don't meet everyone's needs. In particular, they ignore a number of basic considerations that you need to keep in mind.
First, how much money you already have plays an important consideration in determining the right asset allocation. To take a ridiculous example, say you win the lottery and have $50 million. No matter what age you are, you'd be able to live perfectly well on completely safe investments, and investing in higher-risk assets would only subject you to the potential to lose money.
Second, how much money you expect to need also affects the model you should follow. If you can live on relatively little income in retirement, then a less aggressive asset allocation model could still work. But if you expect to need a lot more money than many, then boosting your stock allocation could be the right move.
Finally, many people invest not just for themselves but for their families as well. If you're planning to leave substantial assets for your heirs, then an investing strategy that takes the long-term nature of your portfolio into account is often best even as you grow older.
Not all stocks are created equal
Another basic thing to understand about asset allocation is that not all stocks have the same risk profile. Conservative stocks that give you a smoother ride may allow you to boost your stock allocations, giving you better risk-adjusted returns.
In fact, sometimes, less-volatile stocks actually perform better than their more volatile counterparts even before adjusting for risk. For instance, Hershey (NYSE:HSY) and General Mills (NYSE:GIS) have put together good track records of returns over the past several years despite having much lower volatility than the average stock in the S&P 500, even though they've had to overcome higher input costs to do it. Altria (NYSE:MO) has more than doubled in the past five years despite giving investors a much smoother ride than most stocks and even with falling cigarette volumes in the U.S. having a negative impact on its business.
Even when returns lag the overall market, less-volatile stocks can still have other attractive attributes. For instance, Merck (NYSE:MRK) and AT&T (NYSE:T) both offer attractive dividend yields, rewarding patient investors with regular income. Despite facing specific business challenges, both stocks have survived past difficulties and come out with potential for growth.
Go beyond cookie-cutter strategies
Traditional asset allocation models that point you to fixed percentages are useful benchmarks, but you shouldn't just follow them blindly. Instead, adjust those models to fit your circumstances, and they'll serve you much better.
For the stock part of your asset allocation, the best investing approach is to choose great companies and stick with them for the long term. In our free report "3 Stocks That Will Help You Retire Rich," we name stocks that could help you build long-term wealth and retire well, along with some winning wealth-building strategies that every investor should be aware of. Click here now to keep reading.
Fool contributor Dan Caplinger has no positions in the stocks mentioned above. You can follow him on Twitter @DanCaplinger. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend AT&T. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.