It's probably the most important retirement question you can ask. But, unfortunately for you and for financial advisors, there’s no right way to answer it. The question is: How should I allocate my assets?
Asset allocation 101
Simply stated, asset allocation means diversifying your investments. It's best expressed by the adage "don't put all your eggs in one basket."Investing in just one type of security -- be it high-yield stocks or government bonds -- subjects your portfolio to potentially devastating market fluctuations. A study by Brinson, Hood and Beebower found that asset allocation causes more than 90% of volatility in an investor's returns.
Consider this example from the book The Four Pillars of Investing, by William Bernstein: During the 1973-1974 bear market, investors who only held stocks found themselves down more than 40%. But, investors who diversified by holding 25% stocks and 75% bonds lost less than 1% of their net worth.
Still, asset allocation is more than just owning both stocks and bonds. How much you hold of each asset is just as important as the assets themselves.
For example, during the 2000-2002 bear market, a portfolio comprised of 80% stocks and 20% bonds lost a whopping 25.8%. But, a portfolio with 20% stocks and 80% bonds actually gained 16.5%, according to research in The Boglehead's Guide to Investing.
Guidelines to proper asset allocation
How to effectively allocate your assets for future market performance is, however, a matter of personal preference and perception. The decision is based on factors like: 1) how much investing knowledge you have, 2) how long you think you might live and 3) how much of a legacy your hope to leave to your family. Each decision will influence your investing strategy.
While there are no hard and fast rules to effective asset allocation, here are some guidelines to a stress-free retirement:
1. Balance risk with reward.
A successful portfolio does just that. Fixed income tends to be more secure, but equities tend to return more over the long-term. In general, based on historical statistics, you can expect equities to return an average of 10% annually, fixed income to return 5% yearly, and cash or equivalents to return 3% in the long-term.
The first step to appropriate asset allocation is to decide how much you want to allocate to lower-risk, lower-return fixed-income instruments (such as bonds and preferred stock) and how much capital you want to put toward higher-risk, higher-return equities.
In addition to stocks and bonds, your investment choices might also include money market funds, gold and silver, and insurance products, like annuities. If you're a collector at heart, then you could try to invest in rare coins or baseball cards.
2. Find the right mix.
Although there's no set rule for how you should allocate your assets, a conventional guideline is the 100 minus your age calculation. Take 100 minus your age as the percentage you should hold in stocks; the balance should be in fixed income. For example, if you're currently 65, you’ll want keep 35% in stocks (100-65=35) and 65% in bonds (100-35=65).
3. Adjust as you age.
As long as you don't live beyond age 100, the above formula will suit you fine. But maybe you're a regular runner on a macrobiotic diet -- or you've been blessed with great genes. In that case, there are arguments the calculation should be increased to 110 or 120 minus your age. At 120 minus age 65, you’ll want to keep 55% in stocks (120-65=55%) and the remaining 45% in fixed income. Notice how the allocation of stocks to fixed income increases the longer your expected lifespan.
4. Use an online calculator.
If you find the above “100/120 minus your age” guideline too general and still feel unsure about how to allocate your assets, you can try a free online calculator, like the ones found here and here. By putting in numbers like the value of your current or planned portfolio and how many years you plan to invest, an asset allocation calculator can help you fine-tune your investment strategy.
5. Have enough capital.
The key to a financially comfortable retirement is to have your assets outlive you. A good target is to have enough capital to comfortably withdraw an average of 4% annually for the rest of your (and your spouse's) life. This 4% withdrawal guideline is based on an average portfolio growth rate of 7%, minus an average 3% inflation rate. Additionally, you'll want the income from your investments to supplement any pension and old-age income you might receive.
6. Protect yourself from inflation.
Inflation is an important factor to consider in retirement planning. During the past century, inflation has occurred at an average clip of about 3.4% annually. When allocating your assets, think about how factors such as your age and your current level of capital might be affected by future inflation. Plan accordingly. For example, you might want to allocate at least 10% of your investment portfolio to gold. Historically, gold has held or increased its value during high inflation periods.
Action to Take --> Asset allocation can be daunting. But, taking the time to plan and design an ideal portfolio is worth its trouble in gold. Consider you age, your risk tolerance and your income needs. Then decide on the investments that are best suited for you. A well-planned allocation strategy may allow you to achieve even the most optimistic retirement dreams.