“Once you set your asset allocation, stick to it no matter how greedy or scared you become.” – John Bogle, Founder of The Vanguard Group
Your asset allocation is one of the most important decisions you can make when figuring out how to invest your retirement funds. Studies on the subject vary, but many show that asset allocation could explain up to 90% of the variation of your investment performance. Your asset allocation mix helps structure your investment plan. It shapes your risk tolerance, diversification, goals and time horizon.
What is asset allocation? It’s how you choose to divide the different asset classes in your investment portfolio. A general asset allocation could be a mix of stocks, bonds, commodities and cash. Getting this decision right in the long run is much more important than the individual stocks or mutual funds that you choose.
If you choose to put 100% of your investment funds into stocks then you will have to deal with only the returns and volatility of the stock market. As we have seen in the last 10+ years, stocks can and will fall over time (as much as 50% for the entire market twice in this century alone). You will not get the diversification benefit of having other assets (bonds, commodities, and cash) in your portfolio that are uncorrelated to stock returns.
That is the point of diversification. You can lower the risk of larger losses and increase your long-term performance. Many call this the one “free lunch” offered on Wall Street.
Here are some general definitions that you can follow to understand the markets that you will be choosing for your asset mix:
Warren Buffett once said not to invest in stocks unless you are willing to lose 50% of your money. Stocks are volatile. They move up and down from day to day and week to week without reason.
But over the long-term (let’s say 20 years and over) they are the best returning asset. That may not always be the case, but in general, the more risk you take, the higher the long-term return should be. And stocks have more risk than bonds and cash. By owning stocks you get to participate in the profits of corporate America.
Bonds are investments made in some type of credit product. Interest payments are made on a periodic basis so they are a better bet for getting a sustainable cash flow (or yield). Bonds can be borrowing for corporations, mortgages, car loans, credit cards, governments or any number of reasons that debt is created to fund something.
Think of bonds as a repayment of a loan to the owner of the bond. Bonds are generally safer than stocks because the risk of losing your principal capital is lower. That doesn’t mean it can’t happen, because it can. Some bonds are riskier than others and the price you pay can make a huge difference. And borrowers can default on their loans.
That’s why it makes sense to diversify in bond funds to spread out your risk. Most people look at bonds as a way to limit losses and preserve capital. My first boss out of college once told me that stocks are for making money and bonds are for keeping money.
One caveat to remember is that bonds have had the wind at their back for the past 30+ years in a declining interest rate environment. Bond prices and interest rates are inversely related, meaning when one goes up the other goes down. With rates very low at the moment there is the risk that rates rise and bonds don’t do as well as they have in the past. Just a word of warning.
Cash is the place you keep your spending or future tactical investment funds. You can consider savings accounts, money market funds and short term CDs forms of cash. This is not a place that you want to have your funds over the long term. Over the long term the rate of inflation will eat away any interest you make on your cash funds.
So if you just have a savings account for your retirement savings you will have an impossible time (unless you save like crazy) reaching your retirement goals. Cash will make you a small amount of interest but you won’t lose any money, which is the point. If you have over 5 years until you will need to spend your savings you should probably not keep it in a cash product.
Now that we know the basic asset classes, let’s look at how you can put your asset allocation plan into practice. Before you try to figure out the exact percentages of your asset mix you need to decide how much work you would like to put into your process. Listed below are three different categories that vary depending on how hands on you would like to be with your investments.
The easiest way to set up your asset allocation is to simply buy a target-date retirement fund. All the fund companies offer this type of fund and usually it is your default 401(k) selection until you make your own choices. Your asset allocation is determined by the fund company based on which year you choose for the fund.
So if you plan on retiring 30 years from now you would probably choose a 2040 or 2045 target-date fund. Then the fund company will select a reasonable asset allocation mix more heavily weighted in stocks early in the fund’s life with more bonds and less risky investments added as you approach retirement. The fees are higher for these funds than index funds because the fund company will be making the investment decisions for you.
Candidates for the Easy Allocation:
- Want to be completely hands off with their investments (leave it up to the pros)
- Don’t want to spend any time thinking about how their investments are allocated or do any rebalancing (getting back to target asset weights)
- Don’t care about following the various markets and would rather spend their time focusing on other things
- Don’t want to make any tactical moves with their retirement funds
- Don’t want to spend time following their investments on a regular basis
This allocation strategy requires a little more work on your part with choosing funds, rebalancing and picking the right asset allocation mix. But the number of funds you need for this strategy is very small. For stocks and bonds you simply choose a total stock market fund of ETF. After each fund option I’ll give you a Vanguard Fund symbol that you can look into further. Most retirement plans will have a similar fund offering.
You could choose a total U.S. stock market fund (VTSAX), a total international stock markets fund (VTIAX) and a total bond market fund (VBTLX). If that’s too many funds for you, simply choose a total world stock market fund (VHGEX) to pair with the total bond market fund. That would give you a whole diversified portfolio in 2 to 3 mutual funds. Then you just decide on an asset allocation depending on your risk profile and time horizon until retirement.
Set a rebalance frequency and you have a nice portfolio that will give you market returns at a low cost. You will have to adjust your allocations over the years but this shouldn’t be too difficult with such a small number of funds. This approach allows you to make some tactical bets between stocks and bonds depending on how you feel about the markets (but still try to stay within certain bands around your target asset allocation).
Candidates for the Moderate Allocation:
- Want a simple portfolio but don’t want to have to pay the higher fees involved with target-date retirement funds
- Enjoy coming up with your own asset allocation but don’t want to have a high number of funds
- Want the ability to over- or under-weight an asset class
- Don’t want to have to obsess about fund holdings but still like to check in occasionally
This is for those who like to choose their own funds, either active or passively managed (I recommend the passive or index fund approach). With this allocation strategy, you can choose funds for stocks, bonds, commodities, REITs or any other market you may be interested in. And within those markets you can get specific with growth, value, large cap, mid cap, small cap, international, emerging markets, high-yield and so on.
This will require more funds, more time, more research and generally more complexity. If you use this approach I recommend you still have a defined asset allocation but maybe set aside 10% for tactical investments in different markets. Or you can give yourself plus or minus 5-10% to deviate from your asset allocation target weights.
That allows you to make strategic moves without completely sacrificing your risk profile. But you still need to rebalance at least annually to keep yourself from making your bets too large.
Candidates for the Hands-On Allocation:
- Enjoy researching the various markets
- Want to make changes to their portfolio over time
- Want greater diversification within each asset class
- Have the time to monitor their funds more than a few times a year
Those are 3 very basic ways you can set your asset allocation. You may have to make a few adjustments to yours based on what fund offerings your workplace retirement plan offers or which fund company you choose for your IRA contributions.
But this exercise should give you a good idea about how involved you would like to be with your portfolio. If you enjoy following the markets, maybe the Hands-On approach is for you. If you couldn’t care less and just want someone to take care of it for you, choose the Easy approach. Or you could be somewhere in the middle and make your own tweaks.
Whatever the case may be, you should be asking yourself how much time you would like to spend making investment decisions so you know what to expect once your savings start to grow. This is a common sense decision that needs to be made early on so you can set up your investment plan in the right way.
In my next post, I will go through an exercise that will help you to determine what the correct weightings are for your own situation.