When it comes to asset allocation, the biggest decisions come down to how much you should have in cash, how much in bonds, and how much in stocks. The Fool's four rules for asset allocation will help you slice up your portfolio into these important pieces.
Rule 1: If you need the money in the next year, it should be in cash.
You don't want the down payment for your vacation home to evaporate in a stock market -- or bond market -- crash. Keep it in a money market or savings account. If you're looking for the best yield, check out such national, Net-savvy banks as Virtual Bank and ING Direct. And, of course, make sure it's FDIC-insured.
Rule 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.
Whether it's your kid's college money or the retirement income you'll need in the not-so-distant future, stay away from stocks.
As with all investments, risk and reward go hand-in-hand when it comes to "safe" assets. So, in order of "safest" to "still safe but technically riskier," we have Treasury notes and bills, CDs, and corporate bonds. That's also the order of lowest- to highest-yielding. CDs are still very safe (as long as they're FDIC insured), can usually be bought commission-free, and you should be able to find some that pay a percentage point above Treasuries. Shop around for the best rates; your local bank may not be the best-yielding option.
As for corporate bonds, the general rule is to choose bond mutual funds if you have less than $25,000 to $50,000 to invest. That's because buying individual bonds can be tricky. With a stock, you can pull up a quote on your computer and -- presto! -- you have a good idea of the going price. However, most bonds don't trade on a centralized exchange. And instead of charging a commission, most brokerages (discount and full-service) embed a "markup" in the price of the bond. This makes it difficult to know what fees you paid.
It is gradually becoming easier (and more cost-effective) to buy individual bonds, so it can be done if you're willing to put in the effort. The advantage of individual bonds over bond funds is you know exactly how much you'll get back when the bond matures. However, since bond funds don't technically "mature," you don't know what your investment will be worth when you need the money. In fact, they can lose quite a bit of money, which can be inconvenient if it happens right before you need it.
If you're going to choose a bond fund, stick with short- to intermediate-term bonds (i.e., bonds that mature in two to five years). And be vigilant about costs -- you can find plenty of good funds with expense ratios below 0.50%.
Rule 3: Any money you don't need for more than five to seven years is a candidate for the stock market.
We Fools are fans of the stock market, and we know our history. According to Ibbotson, large-cap stocks, on average, have returned 10.4% annually from 1926 to 2007, compared to 5.5% for long-term government bonds and 3.7% for short-term Treasury bills.
However, investors in stocks have to keep that "long run" part in mind, since in the short run, no one knows what stocks will do. Make no mistake: Even if you're in or near retirement, a portion of your money should be invested for the long term. That's because, according to the Center for Disease Control, a 55-year-old can expect to live another 26 years. A 65-year-old has another two decades. The average 75-year-old lives into her late 80s. A 110-year-old, however, should sell everything and get to Vegas while he still can.
So unless you're a 95-year-old skydiver who smokes, expect your retirement to last two to three decades. To make sure your portfolio lasts that long, you should ...
Rule 4: Always own stocks.
Over the long term, equities are the best vehicles to ensure your portfolio withstands inflation and your retirement spending.
According to Jeremy Siegel's Stocks for the Long Run, for every rolling five-year investing period since 1802 (i.e., 1802-1807, 1803-1808, etc.), stocks outperformed bonds 71% of the time. Stocks beat bonds in 80% of the rolling 10-year periods, and essentially 100% of the rolling 30-year periods. For holding periods of 17 years or more, stocks have always beaten inflation, a claim bonds can't make.
The bottom line is that when you need your money will partially dictate where you put it. What else determines your asset allocation? That favorite term among financial gurus: your tolerance for risk.