A classic strategy for managing risk depends on introducing variety into your investment diet.
How many times did your parents remind you to eat balanced meals so that you’d grow up healthy and strong? When they said balanced, what they had in mind was probably more vegetables and protein and less ice cream and fries.
Making smart investment decisions actually works a lot like putting healthy meals together. But with investing, the balanced approach is called asset allocation. It means assigning percentages of your principal to several different investment types or asset classes, including stocks, bonds, and cash.
ASSESSING ASSET CLASSES
One reason to allocate among asset classes is to take advantage of the ways different classes perform:
- Each asset class provides strong returns in some years and weak returns in others. For example, large company stocks gained more than 26% in 2009 and another 15% in 2010. But that followed a 37% loss of value in 2008, the biggest drop since 1931.
- The major asset classes tend to shine at opposite times. In years—or periods of years—when stocks provide a strong return, bond returns are often weak. And when stocks falter, bonds often shine. There have also been a few years when you could have earned more by keeping all your money in cash, measured by the return on US Treasury bills, than in either stocks or bonds.
- You never know which asset class will be strong, or how strong it will be, in any given year or period of years. So the wisest move is to include several asset classes in your portfolio. That way, you get the double advantage of benefiting from gains in the asset class or classes that are doing well, and offsetting some weakness in those that are not.
A MATTER OF TASTE
Deciding what percentage of your investment assets to allocate to stocks and stock funds, what percentage to bonds and bond funds, and what percentage to cash and cash equivalents isn’t a piece of cake. There’s not a standard asset allocation that works for everyone. And the allocation that’s right for you now probably won’t be ideal at every phase of your life. Your financial goals and your risk tolerance influence the allocations you make. But your age is probably the single most important factor. That’s because the element of unpredictability in investing, especially when investing in stocks, stock ETFs, and stock mutual funds, poses less risk if you’ve got a long time to reach your goals. But if you’re counting on your investment assets to meet a near-term goal, you’ll probably want to minimize the risk of losing even some of your principal.
A PLACE TO START
Here’s an easy asset allocation formula: Subtract your age from 100 if you’re a man and from 107 if you’re a woman. Then allocate a percentage of your portfolio equal to your result to stocks, stock ETFs, or stock mutual funds. (The extra years recognize that women, on average, live longer than men do.)
That means if you’re in your 20s, you’d be investing about 80% of your money in stocks to maximize your potential for long-term growth, with the rest in cash, cash equivalents, or bonds.
By the time you get to be 80, you may want to reduce the percentage you’ve allocated to stocks to as little as 20% of your portfolio— unless you’ve already got enough income to live on comfortably. In that case, you might still be investing a substantial portion of your portfolio for growth (and the benefit of your heirs).
Remember, though, that while a carefully allocated portfolio can increase your longterm return and help offset current losses, it can’t guarantee that you won’t lose money on individual investments or that you won’t end up short in realizing your goals.
CHANGING THE MIX
Investment values shift over time, so that an asset class that initially made up 25% of your portfolio might, at some point, increase to 40% while another asset class may shrink from 25% to 10%. For example, investors who have lots of money in small tech companies in tech booms will see the value of those investments balloon to a disproportionately large percentage of their portfolios. Then, if these stocks plummet, as they may well do, holdings in these small companies will represent a substantially smaller percentage of their diminished portfolios.
To make that happen, you might sell some of the investments that have increased in value to buy investments in the asset class that has lost value. Or you might put any new money you’re investing into the currently underperforming asset class.
But that’s not something you need to worry about every day. It’s generally enough to review and rebalance your portfolio once a year. Another approach is to ignore imbalances unless the value of any class exceeds the allocation you originally selected by 15% or more.