“Asset allocation”, or the percentage of your assets (usually just financial ones) that you put into different types of things (stocks, bonds, cash, real estate), has been shown to determine a very large portion of a person’s return. It is also the key determinate in how much volatility your portfolio undergoes.
[UPDATE 12-21-2010: HERE is a very good, quick (5 minute or less), easy-to-use questionnaire from the good people at Vanguard that can be used to estimate your personal asset allocation. It might be a bit conservative for my taste (too heavily weighted towards bonds instead of stocks), but it’s an excellent starting point to get a ballpark stock-to-bond split.]
While there many ways to arrive at a recommended asset allocation, it often helps to have some simple rules of thumb. The general idea is that the older you are or the sooner you need the money, the safer your investments should be. So while a 100% stock retirement portfolio would be great (in my opinion) for a 30 year-old with 30+ years until retirement, it would generally NOT be advisable for a middle-income retiree.
The following rules of thumb that I will discuss assume that the asset allocation is for RETIREMENT, and that the average person won’t be tapping into it until they’re between 60 and 70 years old.
120 minus your age
To simplify between all the different types of assets, people often just make the distinction between stocks and bonds. For people that own homes and keep some petty cash in their savings or checking accounts, I think just talking about stocks and bonds works well for most people. One such stock-to-bond ratio rule of thumb is this: from 120, subtract your age. The remaining number should be in stocks. For example, if you’re 60, this rule would tell you to put 60% (= 120 – 60) of your assets into stocks, and the rest (40%) into bonds.
This rule is definitely simple, and reasonably useful. (It used to be 100 minus your age, but that was when people didn’t live as long.) My criticisms of it is that may tend to put too much of one’s assets into bonds, especially prior to age 60. Historically, stocks have out-performed bonds in almost every 30 year period. Of course, this is no guarantee that they will continue to do so, but it suggests a high probability.
In general, if you have more than 5 – 10 years to go before you need some money, it could be in the stock market. Thus, I tend to recommend that people who still have 10-20 years to go before retirement put all of their money into stocks. This assumes that most people will have some fixed income anyway (like social security.) It also assumes that the person will only be using a small portion of their retirement funds per year (like 4 – 5% of the total account balance.)
Some alternatives
Since I prefer a slightly more aggressive rule of thumb than the above, I came up with the following asset allocation formula: Put 2 times the difference between your age minus 50 into bonds. I.e.: % in bonds = 2*[Your age – 50]
So, if you’re 50 or under, you put nothing in bonds. At 60, you’ll have 20% in bonds (= 2*[60 – 50]), and 80% in stocks. At 70, you’ll have 40% in bonds, 60% in stocks, and so on. This has the virtue of keeping a 100% stock portfolio until you’re 10 – 20 years out from retirement. It also ‘catches up’ to the more conservative allocation by increasing the percentage of bonds in your portfolio by 2% per year after age 50.
Another option might be to just use a fixed allocation like 60-40 or 75-25 stocks to bonds. You might choose to gradually switch from 100% stocks to this fixed allocation over a period of, say, 10 years, like from 50 to 60, or starting 10 – 20 years prior to your target retirement date.
Lastly, you could adjust my 2*[age – 50] formula above to take your target retirement age into account: use % of bonds = 2*[ Age – (Target retirement age – 15) ]. If you’re going to retire at 65, this works out to just 2*[Age – 50] (since 65 – 15 = 50.) But, if you’re going to retire earlier or later, your recommended asset allocation will adjust accordingly.
Conclusion
Asset allocation is important. Within each asset class, always diversify as much as you can. Pick stock and bond index funds with low expense ratios that sample the entire market. (Large cap and small cap, domestic and international for stocks.)
In general, I like 100% stocks as an allocation for retirement portfolios that still have 10 – 20 years until you start tapping them. Then, gradually switch to something more conservation using one of the above rules of thumb, or something more exact like a financial advisor or William Bernstein’s “The Intelligent Asset Allocator”.
Where do you recommend putting your ’emergency fund’? In case you need car repairs, loose your job, etc. On one hand, stocks seem too volatile for this (the last year is an example), on the other hand, you might not really need the money for 5+ years at a time
Yeah, that’s a good question. Since it’s something where you will need the principal but still want a decent return in case the money just sits there for several years, I opt for a bond index fund like Vanguard’s VBMFX (= total bond market fund.)
It gives better yield on average than, say, a money market fund or CD, and only has historically small amounts of volatility (like +/- 10% in principal from peaks to troughs over the past 15 years or so.)
One ‘advanced’ thing I like to do with my emergency fund is put it into a Roth IRA. This is nice because bond interest is taxable at the marginal rate, so keeping the gains in the Roth tax-free improves your yield by a substantial amount. With a Roth, you can withdraw up to the amount of your total (including all prior-year) contributions without any penalties or taxes. BUT, you can’t use any of the gains above your contributions without paying a penalty (they’d just be extra retirement savings.) It just depends on whether the extra hassle of keeping tracking of your contributions (and withdrawals, should you have them) is worth it for the extra money. Right now, with yields around 3.5 – 4%, you’d be looking at an extra 1-1.5% yield thanks to the tax savings. On a $4000 emergency fund, that’s $40 – $60 extra per year (increasing a bit per year as it compounds.)
I wrote about how to do this here: http://wordsofward.wordpress.com/2009/11/03/re-thinking-the-roth-ira-part-2-hack-your-roth/
Hope that helps!