When you start investing, it may be tempting to get hung up on details like price-to-earnings ratio or bond maturities. While these are important factors in investing, one of the most important concepts to get to know early on is asset allocation and the importance of it changing over time.
Asset allocation is an investment strategy used to help build a portfolio that balances risk. It is used to ensure that your investing aligns with your goals, risk tolerance, and time horizon.
In other words, asset allocation attempts to balance risk while the highest return is pursued within the time you have to invest. Before taking a dive into asset allocation, let’s start by briefly touching on what an asset is.
What Are These Assets You Speak Of?
At its heart, an asset is anything of value that you own. That could be a piece of property or a single stock of a company. When you invest, you’re typically looking to buy something that will increase in value.
The three broadest groups, or asset classes, that are generally held in investment accounts are stocks, bonds, and cash. When you invest, you will likely hold proportions of these asset classes. For example, your portfolio might hold 60% stocks, 40% bonds, and no cash.
Each of these asset classes behaves differently over time and has a different level of risk and return associated with it.
Stocks typically offer the highest rates of return, however, with high reward comes high risk—stocks are also the most volatile of these three categories.
In the short term, the return they offer can fluctuate widely, though over the long term, their return is usually positive. In fact, the stock market has historically returned an average of 10% annually .
Bonds are traditionally less risky than stocks and offer steadier returns. When you buy a bond, you are essentially loaning money to a company or a government.
You receive interest on the money you loan, and the principal you paid for the bond is returned to you when the bond’s term is up. However, when buying bonds, investors trade smaller returns for the security they offer.
And finally, cash, or cash equivalents such as certificates of deposit, are the most secure investments but offer very small returns.
What Factors Affect Asset Allocation?
There are three basic factors that will affect your asset allocation—your goals, your risk tolerance, and your time horizon.
Your goals may be short term, such as buying a car next year or saving for a down payment on a house in the next few years; or they may be long term, like planning ahead for your child’s college or saving for your retirement.
Your risk tolerance is how much volatility—i.e., the ups and downs in the market—you can, or are willing to, withstand. This factor is important to get right. If someone takes on more risk than they’re comfortable with, and the market starts to drop, they may panic and sell stocks at an inopportune time.
Investment advisors may use your risk tolerance to help categorize you as an aggressive, moderate, or conservative investor.
If you’re willing to take on a lot of risk, your investment style may be aggressive. Lower risk tolerance may result in a moderate or conservative investment style. The style of investor you are will likely shift throughout your lifetime.
Finally, your time horizon is the amount of time you have to invest before you need to achieve your goal. This factor can help you determine your risk tolerance. For example, if you have a long horizon there is more time to ride out the ups and downs in the market—as a result, your risk tolerance may be higher.
If you have a short-term financial goal and will need your money relatively quickly, your risk tolerance will likely be lower, as you don’t want a market downturn to take a bite out of your investments just when you need to cash them out.
How Do Diversification and Rebalancing Fit In
The old adage, “Don’t put all your eggs in one basket,” is apt for a number of concepts in investing.
Putting all of your money in one investment may expose you to too much risk. When it comes to asset allocation, risk is being managed by spreading money out over different asset classes that are then weighted differently within a portfolio.
Portfolio diversification is a separate, yet related, concept. Within each asset class you may want to consider holding many different assets. For example, allocating the stock portion of your portfolio to a single stock may not be a great idea. Rather, you might try a whole basket of stocks.
If you hold a single stock and it drops, your whole stock portfolio falls with it. However, say you hold 500 different stocks—when one stock falls, the effect on your overall portfolio is relatively small.
On an even deeper level, you may want to diversify across many types of stock—for example, varying by company size, geography, or sector. One way some investors choose to diversify is by holding mutual funds, index funds, or exchange-traded funds that themselves hold a diverse basket of stocks.
As assets gain and lose value, the proportion of your portfolio they represent also changes. For example, say you have a portfolio allocated to 60% stocks and the stock market experiences a rally.
The stocks you hold might appreciate in the rally and now actually represent 70% of your overall portfolio. In order to realign your portfolio to your desired 60% allocation, you might rebalance it by selling some stocks and buying bonds.
The idea of rebalancing works on the level of asset allocation and on the level of asset classes. For example, if your domestic stocks do really well, you may sell a portion to buy international stocks.
You can rebalance your portfolio at any time. You may want to set regular check-ins, whether quarterly or annually. There may be no need to rebalance if your asset allocation hasn’t really shifted. Your one rule of thumb to consider is the suggestion that you rebalance your portfolio whenever an asset allocation changes by 5% .
What is Age-Based Asset Allocation?
The mix of assets you hold will likely shift with age. When you’re younger and have a longer time horizon, you may want to hold more stocks, which offer the most growth potential.
Youth gives plenty of time to ride out volatility in the market, meaning it’s less likely an investor will be forced to cash out stocks when the market is down.
As retirement age approaches and the time the money is needed gets closer, an investor may want to hold more assets in less risky bonds and cash equivalents to help protect the money.
In the past, investment advisors recommended a rule of thumb whereby an investor would subtract their age from 100 to know how much of their portfolio they should hold in stocks.
For example, a 30-year-old would allocate 70% of their portfolio to stocks, while a 60-year-old would allocate 40%. However, as life expectancy continues to increase and people are relying on their retirement savings for longer, some advisors now recommend a more aggressive asset allocation for more time.
As a result, some of the new suggestions have shifted to subtracting your age from 110 or 120 to achieve a more aggressive allocation to stocks.
These are only general rules that can give you an idea of what your portfolio might look like. Each person’s financial situation is different, so each portfolio will vary.
Asset Allocation in Your 20s and 30s
For younger investors, the rules of thumb suggest they may want to hold most of their portfolio in stocks to help save for long-term goals like retirement. Stocks offer the highest potential returns and with a long time horizon, young investors can ride out stock market volatility.
That said, when you’re young, your financial footing may not be very secure. You probably haven’t built much of a nest egg, you may change jobs relatively frequently, and you may have debt, such as student loans, to worry about.
Asset Allocation in Your 40s and 50s
As you enter middle age you are potentially entering your peak earning years. You may also have more financial obligations, such as mortgage payments, and savings goals, such as sending your kid to college, than you did in your previous decades.
You may also still have 20 years or more before you’re thinking about retiring, so especially in the early portion of these decades, one approach is to consider keeping a hefty portion of your portfolio allocated to stocks. This may be helpful if you haven’t been able to save much for your retirement in your lower earning years.
Depending on when you plan to retire, adding stability to your portfolio with bonds as you approach the latter part of these decades might be a wise choice.
Asset Allocation in Your 60s
Once you hit your 60s and you’re nearing retirement age, your allocation will likely shift toward fixed-income assets like bonds, and maybe even cash. A shift like this can help prepare you for the possibility that markets may be down when you retire.
If that’s the case, you might be able to use these fixed-income investments to provide income during the downturn, allowing you to avoid selling stocks while the markets are down—doing so locks in losses and might curtail future growth in your portfolio.
Leaning on the fixed-income portion of a portfolio allows time for the market to recover before you need to tap into stocks.
Asset Allocation in Retirement
Once you’ve retired it may seem like you can kick back and relax with all of your asset allocation worries behind you. Yet, it is as important a factor to consider now as it was in your 20s.
When you retire, you are likely on a fixed income—you’re no longer adding to your savings with earned wages. Your retirement could last 30 years or more, so consider holding a mix of assets that includes stocks and can provide growth.
This can help you avoid outliving your savings and preserve your spending power. It might make sense to hold assets that grow faster than the rate of inflation or are inflation-protected, such as TIPS.
What’s the Deal with Target-Date Funds?
One tool that some investors find useful to help them set appropriate allocations is the target-date fund. These funds hold a diverse mix of stocks and fixed-income investments. As the fund’s target date approaches, the mix of stocks and bonds the fund holds becomes more conservative.
For example, if you are 35 and plan to retire at 65, you could purchase shares in a target-date fund with a target date 30 years in the future.
As you approach retirement, the fund will gradually increase the proportion of fixed-income assets that it holds.
Target-date funds theoretically offer investors a way to set it and forget it. However, they also present some limitations. For one, you don’t have control over the assets they hold nor do you control how they become more conservative—a.k.a. the fund’s “glide path.”
They are one-size-fits-all, and that doesn’t always work with an individual’s particular retirement goals. For example, someone aggressively trying to save may want to hold more stocks longer than a particular target-date fund offers. Also, as actively managed funds, they often come with fees that can take a bite out of how much you are ultimately able to save.
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