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, bonds, and cash—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 class 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.
Need help with investment terminology? Check out our glossary!
There’s no one right allocation for everyone.
But, there are some general allocation guidelines you may want to think about. 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. This is called diversification.
In your portfolio, you’ll likely want a combination of:
- Growth. Stocks are typical growth investments.
- Income. You may need regular income from your investments, especially if you’re retired. Bonds and FDIC-insured Certificates of Deposit (CDs) are typical income investments.
- Liquidity. You never know when you might need cash quickly. In case of an emergency, you want to have funds available in a savings account.
- 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.
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 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.
To find an allocation that’s right for you, consider your age, financial goals, and risk tolerance.
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 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.
Want to estimate how long it will take an investment to double at a given interest rate? Try our “Rule of 72” calculator.
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We believe there are no shortcuts to developing a smart investment program, designed to meet your short and long term objectives. By planning today, you can have peace of mind that you are taking control of your future.
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