Determining Your Asset Allocation
Before you begin choosing your individual investments you need to consider your asset allocation.
Asset allocation is your portfolio’s blend of stocks, bonds and cash. Finding the best asset mix is crucial if you want to meet your goals.
Rules of thumb
A typical balanced asset allocation is 40% fixed income and 60% equities.
A common rule of thumb is that a retirement portfolio should have a percentage of equities equal to one hundred minus your age, and the rest in fixed income investments. Recently that rule has been updated to 120 minus your age.
The trouble with averages and rules of thumb is they provide only general information. They are not tailored to your specific needs.
Calculators to get you started
There are a variety of online calculators, such as bankrate or smartasset, which are designed to help you create a balanced portfolio of investments by determining your optimal asset mix. Since they use your age, ability to tolerate risk and other factors, they can be a good place to start your analysis.
Related: Fun with calculators (and other online financial resources)
Most calculators are set up to assist you with retirement needs, but they can be used for any medium to long-term goal.
Once you’ve decided on your goal, you only need four other pieces of information:
- How much money you need for your goal.
- The number of years until your goal is reached.
- How much you can invest right now (or have invested already).
- How much you can contribute each month.
Limitations of asset allocation tools
If you use several different online asset allocation tools, you may get as many different recommendations for what your asset mix should be. That’s because every tool uses a different set of assumptions, for example inflation rates or returns for each asset class. Some calculators let you put in your own figures for these.
You may find your goal is unattainable with the inputs you submitted. You can play around with the figures, but be very careful about the assumptions you are making, or increasing your weightings in equities to increase returns.
As with rules of thumb, calculators offer general information. For example, someone with stable employment, a generous pension plan and no heirs will likely choose a less conservative asset allocation than a freelancer with three preschoolers, even if the other figures are the same.
Related: The real cost of investing
When I used Bankrate, my recommendation was 25% cash/ 26% bonds/ 49% stocks. I may be a bit more aggressive than others my age because this seems too conservative to me. Personally, I would not hold that large of an amount in cash unless I had some purpose in mind.
Rethinking your risk tolerance
Many of our investment decisions are based on our comfort with taking risks and the right balance of investments for each stage in your life.
People tend to be over optimistic about returns and their own risk tolerance.
When determining risk tolerance try to do so from a long-term perspective. Many of us are influenced by recent events: taking a too conservative approach when markets are volatile and being too aggressive after a long positive stretch.
You also need to think about the likelihood of your needing to withdraw your investments for any reason in the future. This is tough because you just don’t know what the future brings.
Final thoughts
Finding the right mix of investments is an essential part of reaching your financial goals, whether you are just starting to invest and retirement seems far way, or you will need your money in the next few years.
But don’t stop there. Revisit your portfolio at least once a year. Normally your asset mix won’t change from year to year, so you can rebalance your existing investments back to your desired allocation, or adjust future contributions appropriately.
Once your situation changes – getting closer to your goal, for example – you need to adjust your holdings. You can see how asset mixes change in target date mutual funds (also known as life-cycle funds) for a good ballpark. Select the profile that most reflects you.
It is important to choose a methodology, heuristic, or idea that you want to use and stick with it. I think you can change or refine your investing ideas, but don’t keep jumping around with the latest fad, stick with an idea, and think hard before changing (but don’t be inflexible either).
Do what makes you comfortable.
I agree with Marie , revisit once a year. Rebalancing back to your allocation makes sure you have not crept into more risk in a great year or missed buying opportunities in bad.
In some ways I find moving to less equity as we age is less important than having a cash pot. If you have emergency or if close to retiring 3 years requirements in cash then you can sit out storms.
Its more an emotional thing
Many people think bonds are “safe” but if you track the DEX bond universe beloved of indexers ( hurrah ) then plus one interest rates can be minus 7 on that index.
Its the overall allocation that works for you.
Kathy Waite fee only planner Saskatchewan