Allocating your assets

Asset allocation — the way you divide your portfolio among stock, bonds, and cash — has a major impact on reaching your financial goals. Here’s why asset allocation is such a critical principle of sound investing:

  1. No single investment produces the best return year in and year out
  2. Stock has historically turned in the strongest performance in most years and over the long term, but has had major losses in some years and been flat in others
  3. Bonds produce the best returns in some years, but have provided negative returns in others
  4. Cash usually provides the smallest returns, but rarely provides losses

Stock includes stock mutual funds. Cash is usually invested in money market funds, CDs, and Treasury bills.

Market cycles

The ups and downs in any single asset class — such as stocks, bonds, and cash — tend to occur on a different schedule from the other classes. Often, when stocks are providing strong returns, bond returns are flat or even negative. Or, when interest rates are high, bonds and cash may outperform stocks.

It would be handy, of course, to always have most of your money in the class that’s doing the best. But while market cycles are predictable in the sense that every class goes through periods of strength and weakness, the timing is not predictable.

But if you always own some assets in each category, you’ll always be invested in the class that is doing better at any given time. This means you’re in a position to profit from those gains. The gains may also help to offset losses in another asset class.

One approach is to decide on an allocation that is appropriate for your goals, your age, and your tolerance for risk. Basically risk tolerance is a measure of how much up-and-down change in your portfolio value you can stand without bailing out.

Age matters, because the younger you are the more risk you can generally afford to take since you have a longer time to make up for short-term losses. And your goals matter. Accumulating assets so you can achieve them is the reason you’re investing.

What a difference an allocation makes          

Allocation models assign different percentages of a portfolio to different asset classes. A model that allocates 80% to stocks, 15% to bonds, and 5% to cash can be described as aggressive. It may be the most appropriate for younger people or those who have substantial income from other sources. A model that allocates 60% to stocks, 30% to bonds, and 10% to cash is generally described as moderate, and one that allocates 40% to stocks, 40% to bonds, and 20% to cash can be described as conservative.

You can choose one of these models, or tweak one of them, as a way to begin. Over time you’ll probably reallocate as your goals and your timeframe change. You may also want to rebalance to keep your actual portfolio in line with the model you have chosen.

Let’s say you divide your $10,000 portfolio into a 60%-30%-10% stock, bond and cash allocation. The stock market has been booming, and the bond market has faltered. If you add up the value of your investments, your portfolio may have 75% of its value in stocks, 20% in bonds, and 5% in cash.

If you’re committed to your allocation strategy, you can either put new investment money into bonds and cash equivalents, to bring the value of your overall holdings back into balance. Or you might sell off some of your stocks and buy bonds or Treasury bills with the proceeds to return to the original balance.

An easier approach

If juggling your investments to keep your allocation mix the way you want it seems complicated, there’s an easier strategy. If you’re using the moderate 60-30-10 approach suggested above, for example, each time you have money to invest — say $1,000 — you could put $600 into stocks or stock funds, $300 into a bond fund, and $100 into a money-market fund toward the purchase of your next CD or T-bill.

While your overall portfolio may never be allocated as precisely as a hypothetical model, perfection isn’t what you’re after. But by adding money to all three investment categories, in the approximate proportions you’ve decided on, you’ve made asset allocation easier to keep on top of.

And remember, while it may seem smart to keep investing in stocks or bonds while they’re hot, you may increase your risk over time by tampering with the allocation you’ve chosen.

Into the future

It’s just as important to allocate the investments in your retirement funds as it is to direct the money you’re investing on your own. That means putting part of your 401(k) or IRA account, for example, into stocks and some into fixed-income investments, though probably little or nothing in cash.

And it also means looking at the bigger picture of your retirement and nonretirement investments together. For example, if you’re putting most of your 401(k) money in growth mutual funds, you may want to balance that by putting a larger share of your nonretirement money into blue chip stocks and bonds.

Or, if you know you’re eligible for a specific, fixed-income pension when you retire, you may want to invest more heavily in stocks on your own. Sorting out all the details and figuring out the best overall allocation is one of the ways working with your financial adviser may make a real difference to your bottom line.

Added flavors

While stock and bonds are the meat and potatoes of asset allocation, many financial professionals suggest adding a little spice. You could put some money in gold, some in real estate and part of your stock allocation in emerging growth companies.

Branching out can be an acquired taste, though. As you learn more about investing, and have more money to invest, you may decide you’re ready for more adventure. Or you may prefer to draw the line at investments you’re already comfortable with.


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