Here's a common problem: You want to start investing but you’re faced with tens, hundreds, or even thousands of options. Between mutual funds, exchange-traded funds (ETFs), and individual stocks, there seem to be as many choices as stars in the sky.
At this point, lots of people give up, procrastinate, or just pick investments randomly. But it shouldn't be this way. You can build your portfolio methodically just like many professionals do—starting with asset allocation.
It sounds very complicated and technical, right? But it's a simple concept. Asset allocation refers to the way you spread your investing dollars across asset classes such as the 3 major types of investments—stocks, bonds, and short-term investments (such as cash)—based on your time frame, risk tolerance, and financial situation. Those 3 aren't the only asset classes—for example, real estate and commodities are generally considered distinct from the basic 3 listed here.
Studies have shown that the way you divvy up your money across these 3 investment types can have a tremendous influence over your long-term returns—and that's before you've even begun choosing mutual funds or stocks.
Building your investment mix can be fascinating and rewarding, but it is definitely not the only way to invest. For many investors, it may be easier to turn to a target date fund or a managed account to handle the asset allocation. In the case of a target date fund, if you’re saving for retirement, consider selecting a fund with a retirement date closest to your planned retirement age (somewhere around age 65–67 for most people). Or choose a managed account provider who will typically ask questions or have you fill out a questionnaire, which helps to determine the appropriate mix of investments.
Why stocks, bonds, and short-term investments?
Just like individual investments, each investment type plays a role in your investment mix. Here's a brief look at what stocks, bonds, and short-term investments bring to the table.
Stocks seek to provide growth
Stocks have historically provided higher returns than less volatile investments, and those returns may be necessary in order for you to meet your goals. Over the short term, the stock market is unpredictable, but over the long term, it has historically trended up. But just keep in mind that the stock market has a lot of ups and downs, and the risk of loss is much higher with stocks than with other asset classes such as bonds or cash.
If you have decades to stay invested, you are in the best position to take advantage of the long-term tendencies of the stock market. With time to ride out downturns, you may be able to benefit from potential appreciation in your investments as the years pass.
Bonds can play several roles
Bonds can provide a steady return by paying interest over a set period of time. There's a spectrum of risk and return between lower-risk bonds and those that are more risky. The interest rate depends on the credit risk of the bond issuer. Bonds issued by the US government pay a relatively low rate of interest but have the lowest possible risk of default. At the other end, high-yield bonds pay a higher interest rate than Treasury securities, but there's a substantial risk that the issuer won't be able to keep up with payments or pay back your principal.
Because bonds have different risks and returns than stocks, owning a mix of stocks and bonds helps diversify your investment mix. But providing income and diversification isn't the only role bonds can play in a portfolio: Lower-risk bonds, such as US Treasury bonds, can also help smooth out the ups and downs of your overall portfolio, providing some return while guaranteeing the return of principal when the bonds mature. Though you may not risk losing any of your money, losing purchasing power to inflation can be a risk over time with conservative investments, such as high-quality investment-grade bonds.
Short-term investments help preserve your money
For long-term goals, short-term investments are typically only a small portion of an overall investment mix. They generally pay a minimal rate of return but can offer stability and diversification.
Building your investment mix
But how do you know how much money to put toward stocks or bonds? It all starts with you. The basic things to think about include how long you plan to invest (known as your time horizon), your financial situation, and your tolerance for risk.
Risk tolerance is a squishier measure than your time and money situation. History suggests that the more stocks you have in your investment mix, the more your account value may rise and fall over time. Risk tolerance asks you to consider how much stock market up-and-down you're willing to put up with.
It can be a little difficult to imagine how you would feel if the value of your account fell steadily for a period of time. Some people find themselves losing sleep over temporary stock market volatility. That can lead to selling investments at a low point, and ultimately losing money—the very outcome they were trying to avoid. That's why it's vital to choose a level of stock market risk you can live with: It can help you stay invested over time, which could give you the best chance of accomplishing your long-term investing goals.
To determine your personal risk tolerance, it can be helpful to work with a financial professional and complete an investor profile questionnaire. There are also free online tools that can help determine your risk tolerance.
Your risk capacity is another important gauge for how much risk you can take on. It measures your financial ability to weather declines in your account.
If your goal is retirement in 20 years, your ability to take risk in a retirement account would be higher than in the account you use to pay bills. Your retirement account has time to recover from setbacks, and any immediate losses could be recovered. In your bill-paying account, a loss could very well jeopardize your ability to pay rent next month.
It's important to consider both risk tolerance and risk capacity. They don't always match up. Your ability to emotionally endure losses could exceed your financial situation. The reverse is also true: Some people are extremely loss averse no matter how much money they have. It may take an objective third party to help you accurately assess how to balance these 2 issues, so that you have the best chance to reach your financial goals.
For the chance to get higher returns over the long term, investors have historically had to put up with bigger fluctuations in value over the short term. The table “Stock market dips are part of the ride in stocks” illustrates just how wide the swings have been.
It may be necessary to take some risk, but it shouldn’t be more than you can take on emotionally or financially. You don't have to be 100% in stocks to benefit from the way the stock market has historically moved. Adding bonds and shorter-term, cash-like investments to an all-stock investment mix can have a stabilizing influence on the overall investment mix. Because the pattern of risk and returns from bonds and short-term investments is different from stock market returns, adding them to a portfolio of stocks may mitigate some of the overall volatility you experience.
On the other hand, adding some stocks and bonds to a portfolio of stable, short-term cash investments could boost the probability of achieving higher long-term returns.
Your goals and time frame, in addition to your feelings about risk, will be key factors in deciding how to distribute your investments between stocks, bonds, and short-term investments.
Calculating your time frame
Much of investing is goal-based—for example, saving for retirement, to buy a home, or to fund a child's education. That makes it easy to understand how long you may need to be invested in order to hit your goals.
Time makes all the difference. The chart above illustrates portfolios with varying degrees of stock market exposure and how they fared during their worst year and best year, as well as their best and worst 30-year periods. Over a short period of time, the worst-case scenario would have been quite bad if you held a lot of stocks. But with an investment time horizon of 30 years, your worst-case scenario for a portfolio of 85% stocks still would have been better than the best 30-year return for a portfolio of 100% short-term investments. It's not shown on the chart but the best 30-year annualized return for a portfolio of short-term investments is 6.77%.
You simply don't know which outcome you're going to get. Even if you have nerves of steel and ice water in your veins, it would still be a bad idea to invest all of your savings in stocks if you need your money in just 1 year. No one knows what the market will do: Your investments could smoothly appreciate in value, or you could end up losing half of your hard-earned savings simply because it was a bad year in the market. If you needed the cash and had to sell your stocks in this situation, your money wouldn't have a chance to recover from the negative short-term performance.
Being able to stick with your plan through the ups and downs of the market is vital, because staying invested over many years is nearly always preferable to the alternative—letting time go by when you're not in the market.
Asset allocation and diversification
Diversification is the benefit you get from asset allocation. After you've decided on the broad strokes for your investment mix, it's time to fill in the blanks with some investments. While there are a lot of ways to do this, the main consideration is making sure you are diversified both across and within asset classes.
Diversification can reduce the overall risk in your portfolio, and could increase your expected return for that level of risk. For instance, if you invested all your money in just one company's stock, that would be very risky because the company could hit hard times or the entire industry could go through a rocky period, taking the company's stock down with it for a period of time.
Investing in many companies, in many types of industries and sectors, reduces the risks that come with putting all your eggs in one basket. Similarly, spreading your investing dollars among different types of bond issuers and bond maturities can provide diversification on the bond side of your investment mix.
A key concept in diversification is correlation. Investments that are perfectly correlated would rise or fall at exactly the same time. If all of your investments were rising and falling at the same time, you'd experience a lot of fluctuation in the value of your investments. If your investments are going up and down at different times, the investments that do well may dampen the impact of the investments that exhibit poor performance.
The end result for you is less volatility in your portfolio. Keep in mind that asset allocation and diversification influence the level of potential risk and return by degrees—diversification and asset allocation do not ensure a profit or guarantee against loss.
Commit to an ongoing balancing act
Another reason it's important to revisit your investment mix is for rebalancing. Once you've set your asset allocation and investments, chances are it will begin to change as some investments do well and exceed the proportion of your portfolio that you allotted for them. Other investments may shrink. Getting your asset allocation back on track is known as rebalancing. For example, let's say you set your mix to invest 50% of your money in the stock market and, over time, that percentage increased to 65% due to market growth. You may want to make changes to bring it back to your 50% target.
How frequently should you rebalance? It depends on what makes you comfortable, but generally you should check in periodically, whether annually or quarterly, and consider resetting your allocation if it has strayed from your original plan.
Investing can be confusing and intimidating, but it doesn't have to be. With the roadmap provided by a basic asset allocation plan, you might find that planning your investments isn’t so complicated after all.