As logical as it might seem to look for the perfect stock, bond, or mutual fund and make it your investment of choice, that’s not the best approach to meeting your financial goals. No single investment, or type of investments, provides a strong return year in and year out.
The saving grace is that each asset class—stocks and stock mutual funds, bonds and bond mutual funds, and cash and cash equivalents—tends to perform differently in different economic markets. When stocks falter because interest rates are high, bonds often provide a strong return, and vice versa. Rather than risk being invested in the wrong asset at the wrong time, the solution is to divide your portfolio among the various classes so you are always in a position to benefit from whatever is doing well.
The Right Allocation
There’s no one right allocation for everyone. But there are some general allocation guidelines you may want to think about. Perhaps the most important is that every portfolio needs some growth, typically from stock and stock mutual funds, some liquidity, typically from cash equivalents including US Treasury bills and CDs, and, in many cases, some income, typically from bonds.
Most financial advisers suggest that younger investors allocate a greater percentage of their portfolio to growth than older investors since they have more time to recover from a potential drop in value. If you’re in your 30s, you might have as much as 85% of your portfolio in stocks and stock mutual funds and the rest in cash. But if you’re 65, you may choose to reduce your stock holdings to 60% or even less and allocate 30% or more to bonds.
The old rule of thumb was that if you subtracted your age from 107, that number was the percentage you should put into stocks. But to find an allocation that’s right for you, consider your age, financial goals, and risk tolerance.
Staying on Track
Every time the value of the investments in your portfolio changes, the asset allocation you have chosen is affected as well.
For example, you may have decided that you want to keep 70% of the value of your portfolio in stocks. If the stock market soars, the value of your stocks may increase so much that they are worth 90% of your portfolio. To keep your allocation on track, you should review your portfolio annually, and you might want to sell some of your stocks and reinvest the money in bonds or cash. If the stock market falls, however, you’d have to move more money into stocks to get back up to 70%.
Sticking with your chosen asset allocation mix over time can be difficult since it often seems to go against common sense. Who wants to sell when the stock market is booming, or buy when it seems to be on its way down? One solution may be to rebalance only when one asset class exceeds the allocation you’ve assigned to it by 15%. Using such a benchmark can help reduce the stress of wondering whether or not to make portfolio changes and cut trading costs too.
And remember that changes in your personal life, or a major change in your financial goals, may call for a revised asset allocation. Adding a member to your family, for example, might mean you want to put new emphasis on building a college savings account. Taking an early retirement may accelerate your need for regular income.
A Finer Cut
The other part of controlling risk is called diversification. Since there’s no one perfect investment, your goal is to invest in a combination of individual investments across the asset classes that complement your objectives and risk tolerance. For example, you might soften the risk of investing in an aggressive-growth mutual fund by putting some money into a blue chip fund. The former may keep you well ahead of inflation but can expose you to intense volatility at times. The latter is more likely to protect your principal but probably won’t grow rapidly in value.
There are some guidelines to keep in mind as you begin to allocate your portfolio. These include:
- Growth. You’ll want to stay ahead of inflation with investments that increase in value over time. Stocks, stock funds, and real estate are typical growth investments.
- Income. You may need regular income from your investments, especially if you’re retired. Bonds, bond funds, and CDs are typical income investments.
- Liquidity. You never know when you might need cash quickly. In case of an emergency, you want to have some liquid investments, such as money market funds and short-term CDs.
- Risk. There’s no such thing as a risk-free investment. Higher growth and income come with more volatility and the risk of losing your principal. Higher liquidity comes with the risk of falling behind the rate of inflation. Owning a number of investments with different types of risk can help protect you from losing out on any one of them.This article has been republished with permission. View the original article: Portfolio Building.