You have three main choices when it comes to investments: stocks, bonds, or cash. There is no one-size-fits-all answer to the question of proper asset allocation, and your ideal mix depends on your age, risk tolerance, and time frame until retirement. Here’s a guide to help you make the best decisions for the asset mix in your portfolio.
How much of your assets should be in stocks and bonds?
The answer to this question depends on a few factors. Most important is your age — you should keep more of your assets in stocks while you’re younger and have decades to ride out volatility and take advantage of the compounding power of stocks. As you get older, you should begin shifting some (but not all) of your assets into bonds, which are generally lower in volatility and produce consistent, reliable income.
As a general rule of thumb, subtract your age from the number 110 in order to determine your target stock allocation. For example, if you’re 35, this rule says that approximately 75% of your assets should be in stocks.
Of course, some investors have a higher-than-average appetite for risk, while others place more emphasis on avoiding market fluctuations and preserving their capital. If you feel comfortable taking a little more risk in exchange for the potential of higher long-term returns, you may want to substitute 120 for 110 in the allocation formula, resulting in a higher stock exposure.
On the other hand, let’s say that you’re 55 and want to retire early. You have almost enough money to live a comfortable life in retirement, so your main goal is simply not to lose money. In this case, you can use 100, or even less, to determine the proper stock allocation for your age.
The point is that there’s no simple answer. To further complicate matters, there is a wide variety of risk within stock investments. Speculative stocks and established blue-chip companies are two entirely different things, so we’ll discuss that in more detail later on.
How much of your assets should be in cash?
The short answer: not much. A more thorough answer is that you should have a good amount of cash in a readily accessible place such as a savings account. Experts generally recommend that you aim to have six months’ worth of your living expenses in a cash account, in order to be able to cover unforeseen expenses without tapping into your investments, borrowing the money, or selling something.
Provided that you have some sort of emergency fund, we think that 100% of your investment accounts should be in stocks and bonds. That’s not to say you should take risks with all of your money — there are certain types of bonds (short maturity and high quality) that aren’t much riskier than cash and pay significantly higher interest rates than the average savings account.
It’s important to mention that when we say “cash,” we’re referring to actual cash and similar investments such as money market accounts.
Having said all of this, if you need capital preservation (if you’re already retired, for instance), it’s completely fine to keep a small percentage of your investment assets in cash if you don’t feel comfortable being fully invested in stocks and bonds.
What kind of stocks should you own?
When it comes to investing in stocks, whether you plan to choose individual stocks or buy mutual funds or ETFs, you have a lot to choose from. You can pick value stocks or growth stocks, large-, mid-, or small-cap stocks, international or domestic stocks, and stocks on all levels of the risk spectrum. Here are a few basic definitions you should know and then we’ll discuss how you can figure out your stock allocation.
- Value stocks — Companies with solid fundamentals that are perceived to trade at a discount to peers. A value mutual fund’s objective is to identify and invest in a variety of undervalued stocks, with the goal of producing market-beating returns over time.
- Growth stocks — Companies with faster-than-average growth as measured by revenue or earnings. A growth fund’s objective is to identify and invest in the best growth stocks. Generally speaking, growth investing represents a higher level of risk than value investing.
- Large-cap stocks — The exact definitions vary depending on whom you ask, but a large-cap stock is generally considered to be one with a market capitalization of $100 billion or more.
- Mid-cap stocks — Companies with a market capitalization between $10 billion and $100 billion.
- Small-cap stocks — Companies with a market capitalization less than $10 billion.