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It might seem as though the right way to invest is to find the perfect stock, bond, or mutual fund and make that your investment of choice. However, no single investment—or type of investment—provides a strong return year in and year out. That’s why you need to diversify your investments and perform regular check-ins to make sure your portfolio is performing how you want it.
Why is it so important to diversify your investments? Each asset class—stocks and stock mutual funds, bonds and bond mutual funds, cash and cash equivalents—tends to perform differently in different economic markets. When stocks falter because interest rates are high, bonds often provide a strong return, and vice versa.
Rather than risk being invested in the wrong asset at the wrong time, the solution is to divide your portfolio among the various classes so you are always in a position to benefit from whatever is doing well.
The Right Allocation
While there’s no one right allocation for everyone, there are some general guidelines you might want to consider when building a portfolio. Perhaps the most important is that every portfolio needs some growth—typically from stock and stock mutual funds—some liquidity, typically from cash equivalents including US Treasury bills and CDs—and, in many cases, some income, typically from bonds.
Most financial advisers suggest that younger people allocate a greater percentage of their portfolio to growth than older people, since they have more time to recover from a potential drop in value. If you’re in your 30s, you might have as much as 85% of your portfolio in stocks and stock mutual funds and the rest in cash. But if you’re 65, you may choose to reduce your stock holdings to 60% or even less and allocate 30% or more to bonds.
Consider your age, your financial goals, and your risk tolerance when deciding where to allocate funds.
The old rule of thumb for deciding on how much money to allocate was to subtract your age from 107 and use that number as the percentage you should put into stocks. A better way to find an allocation that’s right for you is to consider your age, your financial goals, and your risk tolerance.
Staying on Track
Every time the value of the investments in your portfolio changes, the asset allocation you have chosen is affected as well.
For example, you may have decided that you want to keep 70% of the value of your portfolio in stocks. If the stock market soars, the value of your stocks may increase so much that they are worth 90% of your portfolio. If this happens, you might want to sell some of your stocks and reinvest the money in bonds or cash. If the stock market falls, however, you’d have to move more money into stocks to get back up to 70%.
To keep your allocation on track, you should review your portfolio annually.
Sticking with your chosen asset allocation mix over time can be difficult, since it often seems to go against common sense. Who wants to sell when the stock market is booming or buy when it seems to be on its way down?
One solution is to rebalance only when one asset class exceeds the allocation you’ve assigned to it by 15%. Using such a benchmark can help reduce the stress of wondering whether or not to make portfolio changes—this can cut trading costs too.
And remember, changes in your personal life or a major change in your financial goals might call for a revised asset allocation. Adopting a baby, for example, might mean you want to put new emphasis on building a college savings account. Taking an early retirement could accelerate your need for regular income.
Diversification is the other part of controlling risk. Since there’s no one perfect investment, your goal is to invest in a combination of individual investments across the asset classes that complement your objectives and risk tolerance. For example, you might soften the risk of investing in an aggressive-growth mutual fund by putting some money into a blue chip fund. The first mutual fund might keep you well ahead of inflation, but can expose you to intense volatility at times. The second is more likely to protect your principal, but isn’t likely to rapidly increase in value.
Here are some guidelines to keep in mind as you begin to allocate your portfolio.
- You’ll want to stay ahead of inflation with investments that increase in value over time. Stocks, stock funds, and real estate are typical growth investments.
- You might need regular income from your investments, especially if you’re retired. Bonds, bond funds, and CDs are typical income investments.
- You never know when you might need cash quickly. In case of an emergency, you want to have some liquid investments, such as money market funds and short-term CDs.
- There’s no such thing as a risk-free investment. Higher growth and income come with more volatility and a greater risk of losing your principal. Higher liquidity comes with the risk of falling behind the rate of inflation. Owning a number of investments with different types of risk can help protect you from losing out on any one of them.
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