One of the most important themes that you’ve probably noticed here at The Finance Twins is that we want to help you realize that saving and investing for retirement can be simple. Many commercials and ads make it seem way too confusing. They want you to think that you need THEM to help YOU. Asset allocation is a perfect example of that.
This complicated term means little to nearly everyone we’ve asked, and scares off many people who are new to investing. After all, asset allocation sounds like it’s a complicated topic. It’s not.
First, let’s break up ‘Asset Allocation’ into the two words it’s comprised of. To begin, an ‘asset’ is simply any property you own which holds value. In this post we will only be talking about your cold hard cash when referring to the asset half of asset allocation.
‘Allocation’, on the other hand, simply just means the process of distributing something.
So if we put them together we realize that ‘asset allocation’ is basically the process of deciding how you want your money invested.
Not too complicated, right?
Now, let’s take a look at the factors that come into play when thinking about what to invest in.
Risk Tolerance in Asset Allocation
The single most important factor when it comes to asset allocation is RISK. This is a very personal decision that only you will be able to answer for yourself. How much risk can you tolerate? If you are young and have 30 years left until retirement, you are much more likely to feel confident taking more risks with your investments than the 64-year-old looking to retire next year.
Everyone has a different tolerance when it comes to risk. When you hit your first bear market and your investment starts to go down will you become sick to your stomach and want to sell all of your stock? Or will you ride it out and keep putting more money in, confident that the market will eventually recover? Again, this is a personal decision that only you can make and it varies by person.
Stocks vs. Bonds
We all know what stocks are, but bonds are less well known. A bond is essentially a loan or debt issued by a company or government that is sold to investors. The investor earns the interest rate on the bond in addition to the amount lent.
Basic investment portfolios consist of stocks and bonds. In general, most people think of stocks as being more risky and bonds as less risky. The percentage you have of each is what determines the risk profile of your portfolio. A portfolio that is 100% stocks is considered extremely risky, while a portfolio consisting of 100% bonds carries the least risk.
You may be wondering, wouldn’t everyone just want to invest everything in bonds since that is the less risky option? That’s a great question, and it leads us to look at expected returns. Most people have heard the quote “With great risk, comes great reward.” Historically, stocks have generated a greater return, otherwise no one would invest in the stock market.
According to NYU’s leading finance professor, Aswath Damodaran, Ph.D., between 2008 and 2017, the S&P 500 had an average annualized return of 8.42%, while 10-year treasury bonds had a return of 3.86%. This risk premium of 4.56% (stock returns minus bond returns) essentially compensates stock investors for the additional risk of owning stocks.
To highlight the risk, let’s look at the lowest historical returns. In that same period (2008-2017), the year with the lowest S&P 500 returns was 2008 with a return of -36.6%! In contrast, the lowest 10-year treasury bond return during that identical period was only -11.1%. Past performance is no guarantee of future performance, but this should start to give you a sense of the volatility or uncertainty of investments. This knowledge can help you determine your risk tolerance.
Your Long-Term Investments Be Comprised Of Index Funds
It’s also worth mentioning here, that we ALWAYS recommend that people invest their money in index funds, rather than picking individual stocks! Once you decide on your share of stocks and bonds, you’ll want to pick index funds that are made up of a bunch of different stocks and bonds. You do this to diversify your investments and to track the broader market. The reason you want to track the broader market, is because between trading commissions and bad bets, you won’t be able to consistently beat the market over the long term by picking individual stocks.
We can’t stress the enough, because we get asked daily for advice on picking stocks. We hear things like, “what do you guys think about buying Facebook or Apple stock right now?”. You don’t want to tie a large part of your net worth to just a few companies. Indexes are the way to go, people!
Example portfolios and their Asset Allocation
When it comes to deciding what your risk tolerance is and how you should allocate between stocks and bonds, there are rules of thumb that you can use.
We love the wisdom shared by John Bogle, founder of Vanguard, in his latest book, with regards to this topic. For younger investors, he recommends investing 80% in stocks and 20% in bonds. He drops this down to 70% stocks for older investors (45yrs +). For those already retired, a split of 60% stocks to 40% bonds or 50% / 50% is more sufficient.
Take a look below at some example portfolios using the 80% / 20% allocation.
Example 1: Two Fund Portfolio
Example 2: Three Fund Portfolio
Example 3: One Fund Portfolio
For those who are looking for an even easier way to handle asset allocation and don’t want to think about more than a single investment, there’s something for you too. Our post last week highlighted some available index funds called Target Date Funds. These funds handle the task of asset allocation for you.
You simply invest in the fund with your target retirement date, and they handle the allocation and rebalancing for you! These funds increase the % of bonds as you approach the target date. For the majority of people, we think this is an AWESOME choice! For reference, the 2055 target date fund currently has an allocation of 90% to stock, while the 2025 fund has 63% in stock.
One topic that we also want to touch on briefly is portfolio rebalancing. Let’s assume that you are younger and have a few decades left before retirement. Given your time horizon and appetite for risk you might feel comfortable with investing 90% in stocks and 10% in bonds (like the 2055 taget date fund).
If your low-cost equity (stock) index fund outperforms your bonds, you might realize at year end that your allocation to stocks has grown to 95% stocks. In order to rebalance your portfolio back down to 90% stock (or lower) you can either sell some of the stock index funds to buy bonds, or simply invest more into bonds with your new savings and investments.
The goal here is to have your asset allocation reflect your risk tolerance. As you have children or experience other life events your risk tolerance will probably shift one way or another. Rebalancing is simply shifting your portfolio back to your desired allocation. We think looking at this once a year is sufficient for most of you, since there’s other things you probably like doing in your spare time.
Don’t forget that asset allocation applies to ALL of your investments, regardless of whether they are in a 401K, IRA, Roth IRA, or taxable trading account!
With tax day approaching, did you already contribute to your IRA for 2017? Let us know in the comments below!