Asset Allocation 101 (Part 1)

The single most important thing to the success of your investment portfolio after your contributions is your asset allocation. Simply put, your asset allocation is how weighted you are towards different investment types (US Stocks, Bonds, Emerging Markets, etc…).

I’m going to say something now that may hurt your feelings, but its 100% true and needs to be said. You aren’t smart enough to beat the market. If you try to be a “trader” and time the ups and downs of the market or constantly try to find the next “hot” stock. You’ll most likely do more harm to your account balance than good. For us small time investors the key is to spread out our risk and try to achieve a return around the market average.

But first things first. We have to lay down some ground rules for your hard-earned cash.

  • If you think you’ll need to use the money in the next 12 months, keep it in cash. Even the safest investments involve risk, and if you’ve followed the news over the past few years its easy to understand why you don’t want the money marked for the down payment on your house disappearing with a downward swing in the markets. So whatever cash you think you may need in the next 12 months should be in cash.  Search around for the best savings account rates at different banks, but I’d recommend a high-yield online savings account from places such as HSBC Advance, ING Direct or Ally Bank. They generally offer a higher interest rate and are just as safe and convenient as an account with your local bank.
  • Money you don’t “need” for 1-5 years should be in safer, income yielding investments. If the purchase of that home is a few years down the road. Or you’re just engaged and want to start saving for a honeymoon after that wedding down the road . A better place for your money would be “safer” (a totally relative term) investment vehicle like CD’s or Bonds. You can get CD’s with time frames ranging from 6mos to 10years and everything in between, and can get them at any bank. Generally the longer you’re willing to lock up your money in a CD the better rate the bank will give you, but regardless of the time frame you can usually get a better interest rate in a CD than a savings account, it’s just that you can’t withdraw your money from it before the specified time frame. With Bonds it’s generally a good idea to stick with funds or ETF’s such as (NYSE:BND). As with any funds or ETF’s you may buy look for the ones with the lowest fees. In my experience you can never go wrong with Vanguard products in this area.
  • Any money you don’t “need” for a longer period than that is the only money you should consider investing in the stock market. There are several reasons for this. First, stocks are very volatile over short periods of time. If you’ve paid attention to any financial news in the past few years you’re well aware of this. Secondly, we’re not traders. We don’t care about this quarter’s, or next quarter’s earnings. The day-to-day fluctuations in the markets are meaningless to us because we’re not chasing a quick buck by investing in stocks. We’re investing for our life goals. So when we buy stocks, or stock index funds we’re buying for the long haul.

So while stocks do carry the most risk, this risk is necessary to achieve the greatest gains. Look at any                          holding period you want. 3 years, 5 years, 10 years, 15 years etc… and you’ll find that the returns on your                     investment from stocks beat that from bonds and the safer investments. Most importantly the returns from stocks generally outpace inflation as well. This is why you need to invest and not just sit on a horde of cash under your mattress. The average inflation rate over the past 100 years is around 3.4%. Which means each year that passes with that cash under your mattress it becomes worth less and less. While the average return on the S&P500 is between 7-9% (depending on who you trust). So if you had that money invested in a simple S&P 500 index fund or ETF such as (NYSE:SPY) you would have beaten inflation by over 3%. This is why its important to ALWAYS hold stocks in your portfolio.

Asset Allocation is just a fancy term for how you balance the risk/reward of your portfolio. You don’t want to be too weighted towards the safe investments because you’ll lose out on on the big gains stocks can give you. You also don’t want to be too weighted towards stocks or give yourself ulcers watching your portfolio balance wildly move up and down. The key is finding the balance that’s right for you.

A general rule of thumb is to take 110 and subtract your age. and this is the percentage of your portfolio that you should keep in stocks. So if you’re 30 years old, you’d subtract 30 from 110 and voilà! you get 80% of your portfolio that should be in stocks. However this is a general rule of thumb. Every person has a different appetite for risk so take that number and use it as a starting point. If you’re more risk averse take the number you get and adjust it down to be a bit more conservative. If you’re more tolerant of risk, adjust upwards and let it ride!

So now that we have some general rules we can move on to determine what our risk tolerance should be in our portfolio’s in Part 2.


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One Response to Asset Allocation 101 (Part 1)

  1. Pingback: Determine Your Risk Tolerance | The First Million is the Hardest

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