What You Need to Know About Asset Allocation

Image by Shutterstock.com

Asset allocation aims to diversify your retirement account across stocks, bonds, and cash. When managing your allocation, your age is a prime consideration because the older you are, the less investment risk you can afford. In retirement, your risk tolerance decreases dramatically, and you cannot afford wild market swings.

Follow these five best practices for managing asset allocation to increase wealth and achieve retirement goals.  

1.  Consider your age when allocating your assets.

Market corrections are especially problematic when your investment timeline is emotionally and financially short. Because you planned to use the money soon, some of it has disappeared, and your stress level spikes emotionally. There is even a possibility that you will get scared and sell. You risk missing out on potential gains if you sell your stocks at the bottom of the market.

If you adjust your allocation based on your age, you can avoid these problems. 

  • If you’re under 50 and saving for retirement, you may want to consider investing heavily in stocks. Even if the market is turbulent now, you have plenty of years left until you retire.
  • When you reach your 50s, consider allocating 60% of your portfolio to stocks and 40% to bonds. Depending on your risk tolerance, adjust those numbers. Consider decreasing the stock percentage and increasing the bond percentage if risk makes you nervous.
  • In retirement, you may prefer a more conservative allocation of 50% stocks and 50% bonds. Depending on your risk tolerance, adjust this ratio.
  • Hold cash or investment-grade bonds with varying maturity dates if you need money within five years.
  • Make sure your emergency fund is entirely cash. During an emergency, you may need to access this money immediately.

2.  Take into account your innate risk tolerance, not just your age.

Rules 100 and 110 are guidelines for asset allocation based on age. By subtracting your age from 100, the Rule of 100 determines what percentage of stocks you should hold. The Rule of 100 recommends holding 40% of your portfolio in stocks when you are 60.

As people live longer, the Rule of 110 evolved from the Rule of 100. Rather than subtracting 100 from your age, you subtract from 110. 

You are supposed to use these rules to determine your ideal asset allocation based solely on your age. In addition to your age and the time until retirement, there are other factors to consider. Knowing your innate risk tolerance can be just as important. You should be able to maintain peace of mind, regardless of your age, by diversifying across asset classes.

You can buy more stocks if you’re 65 or older, already receiving Social Security benefits, and experienced enough to stay calm through market cycles. If you’re 25 and market corrections frighten you, try splitting stocks and bonds 50/50. The returns won’t be as high as you would like, but you will sleep better at night.

3.  Stock market conditions shouldn’t dictate allocation strategies.

You may be tempted to hold more stocks when the economy is doing well, believing the stock market will rise forever. It’s a mistake to do this. You cannot time the market, and you cannot predict when a correction will occur. Hence, you should follow a planned asset allocation strategy. Market conditions should not influence your allocation strategy. Otherwise, you’re not following one.

4.  Within each asset class, diversify your holdings.

In addition to diversifying across stocks, bonds, and cash, you should also diversify within them. You can do that in several ways:

Stocks:

Investors should hold at least 20 stocks or invest in mutual funds or exchange-traded funds (ETFs). Stock holdings can be diversified by company and market sector. Companies in the utility, consumer staples, and healthcare sectors are generally more stable than those in the financial and technology sectors. ETFs and mutual funds are already diversified, making them an attractive option for small investors.

Bonds:

By investing in bond funds, you can diversify your bond holdings. Alternately, hold bonds from different sectors, maturities, and types. Government, corporate, and municipal bonds are the most common types of bonds.

Cash:

Since cash doesn’t lose value like stocks or bonds, diversifying your cash holdings doesn’t necessarily need to be a priority. To ensure that all your cash is FDIC-insured, you might keep it in separate banks. There is a $250,000 limit per depositor per bank set by the FDIC, but most people don’t keep much cash on hand. A more realistic approach would be diversifying how you hold your cash to maximize your liquidity and interest earnings. It is possible, for instance, to hold some cash in a liquid savings account and the rest in a less-liquid certificate of deposit (CD) with a higher interest rate than a typical savings account.

5.  Manage your asset allocation with a target-date fund.

Another option is available if reading about asset allocation makes you nod off. Investing in a target-date fund, which manages asset allocation, might be a good idea for you. Target-date funds invest in multiple asset classes and gradually shift to a more conservative allocation as their target dates approach. In the fund’s name, the target date refers to the year you plan to retire. The 2055 fund, for instance, is aimed at retirees in 2055.

The best practices for allocating target-date funds are generally followed. Their asset allocation considers your age, and they are diversified across and within asset classes. In addition, these funds are easy to invest in. Apart from the cash in your emergency fund, you do not need to manage your allocation actively.

However, there are some disadvantages as well. A target-date fund does not consider your individual risk tolerance or the possibility that your circumstances may change. For example, you might receive a big promotion that allows you to retire five years earlier. Consequently, you should reassess your portfolio allocations and determine if they’re still appropriate.

You May Also Like