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A Brief Introduction to Asset Allocation

In the wake of the market falling, many have talked about asset allocation being more important than ever. And some of you have asked, “What is asset allocation?” “How should I allocate?”

If you want to read an entire series on the subject, I suggest this guide to asset allocation. I’m going to attempt to answer these questions in brief and general terms, something to give you a basic idea. As my disclaimer says, I am not a financial professional and this is not professional advice about how to handle your investments.

What Is Asset Allocation?

Asset allocation is essentially where you invest your money. It’s generally talked about in percentages, such as “my asset allocation is 60% stocks and 40% bonds.” Generally, it’s used to describe the types of investment you buy, more than the actual investments.

The goal of asset allocation is to create a portfolio that allows for growth and is varied enough to grow even in down markets or if one segment of the market performs poorly. Different people have different goals (Some want $1 mil to retire and others want $10 mil), different risk tolerances, so no asset allocation plan is right for everyone.

Most asset allocation theories are based on age and expected time until retirement. The older you get, the more conservative (cautious) your asset allocation becomes. That way more of your money is in cash (including high-interest savings, CDs, and money market accounts) and bonds (good bonds), which are less vulnerable to the stock market going down. (The bond proportions listed below may include cash parts as well, it’s up for you to decide how much is in cash and what type of cash.)

But when you’re younger, you have more time to take advantage of the overall upward trend of the market (so far) and the ability to earn more with your money. Among other things, this helps you beat inflation—which will eat away your money if stored in a conventional savings account or under your mattress.

Some Possible Asset Allocations

Target Retirement Funds

The simplest way to arrange your asset allocation is by buying a target retirement fund from a trusted company like Vanguard or Fidelity. If, for example, you plan to retire in 2040, you’d buy one targeted for people who retire in that decade. The fund’s manager changes the asset allocations based on what they believe is the best mix for your age.

The advantage of these funds is that you don’t have to know anything about asset allocation but you still get it done. Vanguard and Fidelity are generally considered to have excellent mutual funds (which these retirement “funds of funds” invest in).

The disadvantage is that you don’t get any control. You may be worried that the fund manager is taking too much of a risk or you may think they’re being too conservative and you want more room for your money to grow.

The 60/40 Theory

One of the simplest, and most common suggestion for asset allocation is to allocate 60/40 in stocks/bonds. This is conservative when you’re young and riskier when you’re older, but in the long run it has returned good results.

When it comes to my own risk tolerance, I think it’s good when one is younger but has too much in stocks for someone who is even 10 years away from retirement. At that point you don’t have a long run, you have more of a short run. And at my age, I’d want to have a bit more on stocks. Still for 30-50 year olds, it might be a good answer.

The 120- Theory

Another suggestion is to take 120, subtract your age from it and take that as the percentage that you should be invested in stocks. I don’t think it’s necessarily bad for someone in their 20s to be primarily invested in stocks. At 23, I am (my goal is to have at least 10% bonds by the time I’m 25).

But I think that people who are in their 50s probably shouldn’t be 70% in stocks. That’s quite a risky allocation with less time for making up losses.

A related theory involves subtracting your age from 100 and doing the same thing. It’s a bit more conservative.

The Risk-Tolerance Theory

This theory is similar to the ones above, but is based on how much of your portfolio you feel you can afford to lose. Most of the time, age plays a factor in that. Sometimes it’s just personal preference. Dough Roller outlines it here in a chart midway down the page.

My thoughts

I definitely tend towards conservative investing. I do favor a riskier allocation (well, a normal allocation for many but it feels risky) in your 20s to early 30s. Something like 75-95% in stocks. For mid-30s to 40s and perhaps early 50s, I favor the 60/40 split. After that, I feel more comfortable when I think about having a 40/60 allocation in my 50s and 20/80 in my 60s. Perhaps 90/10 in my 70s.

But that’s not professional advice, that’s based on what I’ve read about asset allocation and how I feel about risk. In theory, this should leave me much less vulnerable than most of the above if I’m in my 50s and the market tanks then less of my portfolio is at risk.

What Your Assets Actually Are

After you figure out how you want to allocate your assets, you have to figure out what kinds of assets you want.

This can be something basic, like having your stock part all in a large cap index fund (such as one that mimics the S&P 500) and your entire bond portion in an equivalent bond fund.

You can break it down between large cap, mid cap, and small cap funds as well as between foreign and domestic stock. You can invest in numerous types of bonds and related securities as well. A lot of it is up to how diversified you want to be and how much you want to learn. A certain measure of diversification is critical, but even the S&P 500 funds give you a decent slice of the market.

What is a good asset allocation? The answer isn’t unique to you—there are only so many combinations available—but it’s specific to you. This article is meant as an introduction to asset allocation and some of the theories. I hope it’s a helpful start to your investing journey.

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{ 5 comments… read them below or add one }

Miranda October 13, 2008 at 11:10 am

Thank you for this great overview. At this time, I think it’s important to take a measured look at your finances and your holdings, and make reasoned decisions. Giving into panic may be what a lot of people are doing, but it is important to take a reasoned approach right now, and consider your needs and the future, and not get caught up in the moment.

ABCs of Investing October 13, 2008 at 1:25 pm

Great post. I definitely think your risk tolerance is a key ingredient in the asset allocation process. It doesn’t matter how much equity you have – if the market drops and you switch to cash then you have probably lost money.

MrsMoney October 13, 2008 at 1:48 pm

I made sure to ask one of our licensed bankers about the asset allocation in my 401k. I wanted to make sure I wasn’t too heavy on one area. Great post!

Writer's Coin October 14, 2008 at 7:15 am

Now is a great time to learn about asset allocation. Just ask anyone over 60 how they feel with the market collapsing like this and you’ll appreciate the need to be mostly in bonds by the time you’re that age. I think, for the average Joe who doesn’t want to tinker with their accounts all the time, that Target Retirement funds are perfect.

Alisa October 14, 2008 at 10:37 pm

Great Info! The proper asset allocation is very important as it may help to minimize investment losses. The stock market has been so crazy lately and I am sure many are ready (if they have not done it already) to just bail out with what may be remaining in their investment portfolios. Although I am just starting out on my investment journey, I am learning that this may also be a time of great opportunity to by shares of good businesses at discounted prices. Be well!

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