The idea is simple, really: Don’t put all your eggs in one basket.
If you’ve managed to save some money, and you keep saving each year, good for you! Being in a place where you’re (presumably) free of bad debt (such as credit card debt) and can save each year is a very good place to be. But it’s not worry-free. If you have a stash of money, you need to invest it – otherwise you risk having it slowly lose its value because of inflation. But where to put your money? That’s where asset allocation becomes your best friend.
Your Investing Options
Suppose you have $10,000 to invest. Your goal is to avoid losing the money (duh), growing it so that it catches up with inflation, and hopefully growing it at a faster pace than inflation, so that you are able to comfortably retire someday.
While putting all your money in an FDIC-insured savings account or buying a Certificate of Deposit may seem to make sense, the reality is that the interest you’ll earn on these investments will be so low that your money will not keep up with inflation and will gradually lose value. So, while the least risky, this is not a very good strategy.
On the other hand, if you’re a risk-taker, you might be tempted to put all your money into the stock market, where it has the potential to give you the best return. Say you begin investing $10,000 today in an index fund, and expect to get the same average return that the stock market has returned since 1926 – 11% annually. With compounding, your money will double every six and a half years, to about $40,000 after 13 years, $160,000 after 26 years, and an amazing 2.5 million after 52 years.
But as we all know, the stock market can crash, and since you never know WHEN exactly it will crash (it could be just as you’re getting ready to retire), putting all of your money there would simply be too risky for most people.
Similarly, bonds can crash too, especially when there are interest rate hikes. With bonds, there’s also the risk of default – and while most of us still believe that United States treasuries are very safe, municipal and corporate bonds do run the risk of default.
If You’ll Need The Money Soon, Stay Away From Stocks
Since any asset group can crash during any given time, but rarely do they all crash at the same time, it makes a lot of sense to divide your precious nest egg between several baskets, diversifying your investments and allocating different portions into different investment vehicles.
You certainly want to have about 6 months’ worth of living expenses in cash – that’s your emergency fund. In addition, if you’re anticipating any major expenses over the next year, such as a wedding, a down payment on a house or purchasing a car, those funds should also be in cash – an FDIC insured savings account, like an online savings account, should work well.
Next, any money you’ll need over the next decade, including money you’ll need during the first few years of retirement, college savings for your kids, or any other major expenses you anticipate, should be in CDs and bonds. This can include treasury bonds, municipal bonds (unless your state is in financial trouble), or high quality corporate bonds.
The rest of your money – anything you won’t need over the next decade – can go in the stock market where it will likely grow nicely and more than keep up with inflation. But as you near retirement, or as your kids near college age, remember the 10-year rule, and pull out of the stock market anything you will need over the next decade. Ideally, you should re-balance your portfolio every year to make sure you are sticking with your basic asset allocation plan and not keeping too much – or too little – in stocks.
Even when you do reach retirement age, it’s important to keep a portion of your money in stocks – this will help ensure that you won’t run out of money. On average, people today live for a LONG time, so don’t be surprised if you’re still alive and kicking at 85 or 90. Retiring at age 65 means you should support yourself for at least 20 years, so – again – keep whatever you’ll need over the next decade in “safer” vehicles such as treasuries, but consider putting everything else in the stock market.
Investing Is Not Just About Cash, Bonds, and Stocks
Remember that in addition to cash, bonds, and stocks, there are other asset classes that you may want to diversify into. These include precious metals such as gold (or a gold fund such as GLD), real estate (or a REIT – a Real Estate Investment Trust), natural resources (such as oil), and foreign currency.
Diversify Your Bonds and Stocks, Too
We’ve already mentioned different types of bonds – treasuries, municipal bonds, and corporate bonds. When it comes to stocks, once you determine how much you can put in stocks, you should further break down your equity investments into additional asset sub-classes. These include company size (large-cap, mid-cap, or small-cap) and the mutual fund’s investment style (growth, value, or a blend). You should also hold part of your stock portfolio in foreign stocks, and perhaps also part of your bond portfolio.
The idea is that different sectors do well – or not so well – at different times, so it’s a good idea to diversify and get exposure to as many asset sub-classes as possible. The larger your portfolio, the more it makes sense to diversify into many sub-classes.
But Don’t Let This Scare You Off!
I said it before, and I’ll say it again: Even though this may sound complicated, mutual fund investing is not rocket science.
If I can do it, anyone can do it. Let’s assume you put the money you’ll need over the next year in a savings account and the money you might need over the next decade into a mix of treasuries, an FDIC-insured CD ladder, and some high-quality corporate bonds. You are now left with $10,000 to invest in the stock market and in other asset classes. In this case, you could do something like this:
$6,000 (60%) – an S&P 500 index fund (VOO)
$2,000 (20%) – a foreign equity fund such as the Vanguard Total International Index Fund (VXUS)
$1,000 (10%) – A gold ETF such as SPDR Gold Shares (GLD)
$1,000 (10%) – a REITs fund such as Vanguard REIT Index ETF (VNQ)
Of course, this is in no way a recommendation, as you should always do your own homework first (try morningstar.com and fool.com) and invest according to your own needs and risk tolerance.
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They developed this pretty nifty 401K Fee Analyzer that will show you whether you are paying too much in fees, as well as an Investment Checkup tool to help determine whether your asset allocation fits your risk profile. The platform literally takes a few minutes to sign up and it's free to use by following this link here. For those trying to build wealth, Personal Capital is worth a look.
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Wow, perspective is a wonderful thing and hindsight surely is 20/20. But with this obviously being an older post from the dates of the comments I just wanted to add a little to it. One of the things I try to teach any young person who will listen is save, save, save until you think you have enough and then save some more because you don’t. Unless you win the lottery or are born or marry into money this is pretty much 100% true for most people. I remember having a 12% and 15% CD many years ago. Ahh those were the days. Of course that was also around when I also got my first mortgage at 8.75% fixed. What a great rate huh? Well it was at the time just before the prime rate maxed out at 21.5% at the end of 1980. So as the saying goes- pay yourself first. And make a lifetime habit of it and invest in solid dividend paying stocks. Be they blue chips or index funds. And definitely stay away from anything that’s charging anywhere near 1% in fees. You would be amazed at what that costs you over a lifetime in lost earnings. You don’t have to be an expert at this, I’m certainly not. But educate yourself on finances and invest as aggressively as you are comfortable doing so. No one is going to watch over your own money as diligently as you are. And don’t forget to have cash for emergencies.
Wow I can’t believe you can borrow at 8.75% in the old days and get a risk free return of 12-15% on a CD!
They don’t call them “the good old days” for no reason!
You are doing the country a great service by telling people you know to save more though. Americans simply don’t save enough period.
It doesn’t matter if the stock market can generate 2% or 20% a year, if you don’t have any money to invest!
Funny, seeing as your suggested portfolio is 90% US stocks
For actual expert asset allocation advice:
http://www.cbsnews.com/8301-505123_162-37842760/how-to-build-a-diversified-portfolio/
I have 10,000 invested in pacific life mod-conservative fund. Should I be more aggressive? I am 55 and need to have money for retirement.
Just a suggestion: investigate the American Funds Capital World Growth and Income Fund if your 401k offers it. The fund has solid long-term performance…I also favor selling some of the fund that has soared recently. Locks in gains and releases $ for investing elsewhere if you are not depositing additional $ into the account regularly.
Sorry I didn’t share more in my first post. I had an old 401k from another employer and when I rolled it over to a Fidelity IRA.
This is a better explanation of my asset allocation:
Fidelity Latin America FLATX up 31.22% in 6 months
Fidelity Select Gold 14.99% up in 6 months
Stock (TAXI) MEDALLION FINL CORPORATION got out of some around 20% and the little I have I am up 8%
Stock (NKE) I was in Nike but sold out after being up 2% in a few days
And a Fidelity small cap discovery fund that I sold out of after being up a few 5%
When I bought into mutual funds and stocks I picked things that make sense to me and kind of balanced out. I had picked all Fidelity 4 and 5 start funds, low management fees (below 1.5).
I picked Gold because of the weak US dollar. Latin America because I have been hearing for a while they are the hot emerging market, and have lots of recent wealth creatin. TAXI because I like that they finance a finite resource such as Taxi Cab Medallions in NYC., and NKE because they seem to be in a far #1 amongst their competitors. The small cap discovery fund was suppose to be a hedge vs gold.
When you buy a mutual fund like Fidelity Select Gold, does that really mean you are rooting for Gold to go up? I do not know, but my feeling is that you are hoping more people buy that fund, and you hope that the fun is making money from whatever transactions they are making (whether long or short).
I wonder where Gold goes from here… Will it ever get back to $1000?
Will it eventually see the $2000 number, and how many years off will that be? 10, 15, 20, 30?
David, can you maybe write up a post about GOLD? and the best ways to invest in it?
-Frugal Francis
I’m currently in Invesco Small Cap, JP Morgan Mid Cap, Lazard Emerging Market, and Morley Stable. I’m very unhappy with our 401k program because they hold almost every mutual fund American Funds have (which Morningstar rates all below average and bottom percentile of funds)
This is definitely one of the issues with 401(k) investing – sometimes the options given are just frustrating.
I am up 27% in 4 months on an Emerging Market Mutual Fund focused on Latin America. The fund is FLATX. Being up 27% in 4 months is awesome, but when do I sell, or do I just hold on for the ride? I have been up as high as 33% in these last 4 months, and now I am at 27%. I am nervous that if I don’t sell and reap my profits, the % may continue to go down? Or if I sell too soon, the % may go back up?
Maybe selling half of my position is a good idea?
Thoughts?
IMO – don’t get too fixated on the gain of one fund. It is more important to keep your asset allocation on target. That’s the point this post is making.
If your Emerging Market gained so much this year, your asset allocation might be out of whack. You can fix it by selling some emerging market shares OR contribute more to the other type of funds to bring the allocation in line again.
The last thing you can do is change the asset allocation, but this is not a good idea because you’re second guessing yourself.
There are mainly two groups of investors who consistently win in equity markets using their own capital. There are the market timers, who look at everything from technical charts to economic fundamentals. These people trade in and out of the market, and play the odds.
The other group is the ones who buy conservative funds, like the S&P 500, and just bet on the economy as a whole and not worry about the ups and downs.
Most people fail when they try to be a mixture of both. They try to time the market without adequate knowledge or commitment to learn and monitor the appropriate metrics.
Without knowing much more than what you described, yes, mathematically, the responsible approach is to sell half and see what happens, though your method of investing is like throwing darts in the dark. You know the board is on the wall, and you know you are aiming at it. The difficult comes because you are trying to hit the bulls-eye, and while you have seen the result, you don’t know how to achieve it.
Try turning on the lights first.
My allocation is much more aggressive. Now is not the time to shy away from international investment. 2010 was a huge year for emerging market, not so much for international due to the European debt crisis.
30% large cap US
10% mid cap US
10% small cap US
20% international (such as DODFX)
20% emerging market (such as SSEMX)
5% bond
5% cash