Deciding on the amount you should have in stocks vs. bonds and cash (known as “asset allocation”) is one of the most important decisions an investor can make. The goal of “asset allocation” is to earn high enough returns to achieve your goals, while limiting the amount of risk that you’re taking.
Over long periods of time (say, ten years or more), stocks almost always return more than bonds. Because stocks are shares of ownership in businesses, they reflect the long term trends of growth in the economy. People invest in stocks because they want their assets to grow. If you are younger and are investing for the distant future (such as retirement that’s at least 15 or 20 years away), and won’t need to withdraw money until then, you can afford to have a fairly high percentage allocated to stocks—even though you will probably go through some major stock market downturns along the way.
If you are closer to the time when you’ll need to start using the money you’ve invested, such as within 15 years of retirement, you should have a lower weighting in stocks than you did when you were younger. This is because in the short run, the stock market has a lot of risk. We don’t have to look any further back than the last couple years to see how much stocks can decline at times. As you approach retirement, you should gradually reduce your weighting in stocks. The best times to do this are during periods when the market has been rising for a while rather than after a big selloff in the market. After you retire, you will probably still need to have a modest allocation to stocks to be able to keep up with inflation.
Bonds and cash are a counterbalance to stocks in your portfolio. These are your preservation and income assets. The biggest long term risk to bonds, assuming you’ve invested in high credit quality bonds, is inflation. It would be very appealing to retire with, say, a $1 million bond portfolio that gives you $50,000 in annual interest income—just the amount you need—and just avoid the stock market altogether. The problem is that inflation will reduce the buying power of that $50,000 each year. In five to ten years, you’ll be drawing down on the principal or looking for a job because the interest income from your bond portfolio can’t pay your bills.
So—what should your personal asset allocation be? What’s the formula to figure it out? For people over 45, the general rule of thumb says that the percentage you have in stocks should be 100 minus your age. However, the best allocation for you may not be quite that simple. For example, if you are behind on the amount you have saved and invested, you may need to have a somewhat higher percentage in stocks at age 50 in order to increase your potential for having enough money when you retire. On the other hand, if you are 55 and worry a lot about losing money during market downturns, you may only be able to handle a small percentage in stocks—and perhaps lower your lifestyle expectations for retirement.
There is nothing wrong with tactically, or temporarily, deviating modestly from your asset allocation target to try to avoid temporary losses or to take advantage of selloffs in the market. However, the temptation we all have is to follow our emotions (and the emotions of the “experts” on the business programs) and sell stocks after the market is already down, and get too optimistic when the market has been rising for an extended period. Try hard to avoid acting on these “knee-jerk” emotions.
A much better approach is to rebalance periodically. This means selling a little of the asset class that has increased its weighting in your portfolio recently, and buying a little of the one that has declined—to get back to your target allocation. If you do that at least annually, you will usually be “buying low and selling high.”
At Tampa Asset Management, we will recommend an asset allocation that we’ve designed specifically for your needs. We’ll pay a lot of attention to how you feel about investing and your personal “go to sleep at night” factor. Over time, we’ll help you change your asset allocation as you get closer to retirement, and as you enter it. It’s part of the solid ground that you should build your wealth on.
Next in the “Rebuild your Wealth on Solid Ground” series (Part 3 of 4):
Guidelines for investing in stocks, bonds, CDs, and cash - while keeping costs low.
