What is the Right Asset Allocation for You?

Sound Mind Investing says that the most important investing decision is determining asset allocation -- how much of a portfolio is allocated to stock-type investments and how much to fixed-income securities such as bonds. The article notes that academic studies have established that as much as 90% of your long-term results can be traced to this fundamental allocation decision.

90% huh? Ok, so I guess it's important. :-)

And before we jump in further, here are some additional comments from SMI that serve to better frame the conversation:

On the one hand, we have stocks, which are volatile but produce high returns. On the other we have bonds, which are relatively stable but produce lower returns. How should you go about combining them in a portfolio?

So, if asset allocation is so important, then we all would like to know what the "correct" allocation is, right? Unfortunately, it's not that easy. It's kind of a moving target based on several factors. Here's how Get Rich Slowly summarizes the issues involved in the allocation decision:

Determining the best asset allocation for your portfolio involves a combination of:

• Investment time horizon — When do you need the money?
• Risk profile — Can you handle the ups and downs of the stock market?
• Rebalancing — This is something you should do once a year or so.

Given these variables, here are three different, though similar, opinions on how we should all set our asset allocations. First, these thoughts from SMI:

The key ingredient in this recipe is time. Over shorter periods, stock returns are much more variable. Maybe you'll do great; maybe you'll do poorly. Given a long time frame, however, you can be quite confident that stocks will provide higher returns than bonds.

That's why it's generally recommended that younger investors take advantage of the many "tosses" in their future by investing heavily in stocks. They can afford to ignore the short-term ups and downs, while focusing on the highest long-term returns possible. Later, as you move closer to retirement and the number of future tosses declines, it's prudent to scale back the short-term risk of loss by gradually increasing the percentage of bonds held in the portfolio.

Ok, so the older we are, the more we need invested in bonds. That's a bit general, don't you think? Dough Roller gets more specific with the standard asset allocation rule-of-thumb:

As a starting point, many view a neutral allocation between stocks and bonds to be 60% stocks and 40% bonds. If you read a lot of the literature on asset allocation, you'll see the 60/40 split used frequently. According to one report published on FundAdvice.com, a 60/40 allocation produced a compound annual return of 10.4% from 1970 to 2006. Now that doesn't mean that a 60/40 split is right for everybody, which brings us to an oft-repeated formula for determining a reasonable allocation: 120 - your age = the percentage to invest in stocks, with the remainder allocated to bonds.

And for one final perspective, the Motley Fool lists the following four rules to setting an asset allocation:

• Rule 1: If you need the money in the next year, it should be in cash.

• Rule 2: If you need the money in the next one to five (or even seven) years, choose safe, income-producing investments such as Treasuries, certificates of deposit (CDs), or bonds.

• Rule 3: Any money you don't need for more than five to seven years is a candidate for the stock market.

• Rule 4: Always own stocks.

This last suggestion is the closest to how I personally set my own asset allocation, but my investments are also fairly close to the "120 - my age" rule as well. Coincidence? Maybe. Then again, maybe both of these are a good reflection of the same principles -- some cash, long-term in stocks, shorter terms in bonds/CDs/etc.

How about you? How do you set your asset allocation?

Comments

[Param]

Someone who is willing to read a simple but effective point of view that may seem unconventional at first but is logically sound, should read Intelligent Investor. Benjamin Graham recommends 50% stock/bond allocation as an all-weather policy that suits almost everyone across ages. I fully support that option...

[Andi]

I'm 100% cash+CDs right now - about $850k - but that is mainly from a lack of options I feel confident in. I'm somewhat sorry its in USD at the moment - I'd rather not invest here until my greencard comes through.

[Rob Bennett]

I believe strongly that we need to add valuations to the mix of factors we consider when setting our stock allocation.

Valuations have a dramatic effect on long-term returns. So there is no one allocation that makes sense both at times of low valuations and at times of high valuations.

Rob

[Kert Noradian]

I believe that investing in index funds is better than investing in individual stocks because of the benefits of diversification. Don't put all your assets in one basket.

Only putting money into stocks and bonds breaks this rule of diversification because you don't have exposure to gold.

Index funds invest in companies based on the value of the company. The bigger the company in terms of market capitalization the more money in the index fund is allocated to the company's shares.

The value of all gold in the world is roughly equal to the value of the world stock market, so your exposure to gold should be roughly equal to your exposure to the shares.

Furthermore, the idea that stocks are volatile in the short term but in the long term they are guaranteed winners over bonds is false. Stocks are not only more volatile than bonds but they are more risky and the risk does not diminish over the long run. Think about it this way. If you play roulette and spread your money all over the table, you are investing in bonds. Chances are your number will come up because you have your chips on so many numbers--but because you have spread your money out so much you will not make much. With shares you are essentially taking all your chips and putting it on one number. The potential for gain is huge but so is the potential for loss.

You cannot guarantee that stocks will go up in the long run because essentially stock prices represent net present value of future dividends. Dividends depend on profit. If shares continue to go up in value forever then it follows logically that corporate profits must go up forever. The only way companies can do this is if there is continually decreasing price of inputs (e.g. oil, metal, etc) or continually increasing technological progress that allows more output to be produced from less inputs. Perpetually decreasing cost of inputs or perpetually increasing technological improvement is definitely not guaranteed, neither in the short term nor in the long term.

I agree that the best way to make and protect money is to earn lots, spend little, and invest a lot. When it comes to investing, there is only one fundamental rule: diversify. Buy everything. Buy stocks, buy bonds, buy gold, buy property, and then buy all types of everything, e.g. physical gold, gold certificates, gold ETFs, bonds from different countries with different levels of maturity, stocks of different companies across different sectors across different countries from different brokers, etc.