Let’s talk about the most important decision you are going to make as an investor – choosing your asset allocation.
Your investing journey should start with identifying your goals, investment horizon, and level of risk you can tolerate and still sleep well at night.
The next step is deciding on your asset allocation. Think of it as a big picture of your investment journey.
Start building your portfolio by finding the right mix of asset classes with a risk profile you’re comfortable with.
Keep in mind that there is no such thing as “good: or “bad” asset allocation. It’s very individual, and you have to figure out what works for you.
What is asset allocation
Asset allocation is the way you divide your portfolio among different asset classes – stocks, bonds, cash, and alternative investments (real estate, cryptocurrency, commodities, etc.)
Different asset classes act differently – have varying risk/return profiles. By deciding what mix of asset classes you will have in your portfolio, you have some level of control of how risky and volatile your investment journey will be.
Why asset allocation is key
Asset allocation is the most important decision you’re going to make. The portfolio’s proportions of stocks, bonds, and other investments determine 91% of its returns as well as its volatility.
Security selection (which particular securities or funds you pick) and market timing (when you buy them) are responsible for the other 9%.
Characteristics of major asset classes
Stocks & stock funds
Stocks inherently have a high level of risk and offer a possibility of high returns. Equities are more volatile, so if you have a longer investment horizon, you have the luxury of time to ride out the ups and downs of the stock market.
Stock prices can fluctuate for several reasons, such as actual performance of a company vs. market’s expectations, state of the overall economy or a particular industry, news related to top management, or even something completely unrelated.
Historically, the U.S. stock market has returned 10.2% a year on average before inflation or 7.1% after inflation.
Bonds & bond funds
Bonds usually carry a moderate level of risk and deliver moderate returns. The main reasons to invest in bonds are either searching for an income stream from getting periodic coupon payments or attempting to offset the more significant risk of investing in stocks.
By investing in bonds, you are trading the potential of higher returns for the possibility of lower volatility.
The most important thing you need to know about bonds is that bond prices and interest rates move in opposite directions. Therefore, rising interest rates are among the major risks of investing in bonds because they could push bond prices down.
Another risk associated with investing in bonds is the bond’s issuer could stop making coupon payments or is unable to pay back the principal. It’s called credit risk.
Historically, the U.S. bonds have returned 5.5% a year before inflation and 2.5% a year after inflation.
Sample portfolio allocation models
How do you pick the right mix of asset classes for you? Always start with your goals, risk tolerance, and investment horizon. As I mentioned earlier, there is no “right” or “wrong” asset allocation model. Decide what you are comfortable with.
To get your wheels spinning, I’ve included nine sample asset allocation models and their historical risk/return profiles. These models can help you tune in to what you think best fits your goals and risk tolerance.
Next step – filling up the asset class buckets
Once you have chosen an asset allocation mix that you’re comfortable with, it’s time to do your research and select appropriate investments to put in each of the asset class buckets.
I am a big fan of index fund investing. Read my post “The Beginner’s Guide To Index Investing” to learn more about index funds and why it’s such an excellent option for individual investors.
Also, I recommend using the ETF Screener & Database to filter through thousands of ETFs (exchange-traded funds) and find suitable investments for your portfolio.
Staying the course
After you’ve decided on your asset allocation and picked the investments for your portfolio, maintaining the desired asset allocation over time is one of the most essential ingredients in your long-term investment success.
I’m talking about rebalancing your portfolio. At the very least, you should check your asset allocation once a year or any time when your financial circumstances change dramatically.
The bigger picture
Investing to achieve your long-term goals requires finding the right balance between risk and return.
Choosing the proper asset allocation and then periodically rebalancing your portfolio will keep you on track and make your investing journey more successful.