Asset Allocation

What is asset allocation?

Asset allocation describes what your investments are placed in. For example, lets say I've invested $5,000 in stamps and $5,000 in coins. My allocation would be 50% stamps and 50% coins. A more realistic example would be having 75% of my investments in a stock index fund and 25% in a bond index fund. In this case, my allocation would be 75% stocks and 25% bonds. This is a common allocation setup.

Sometimes people get complicated with their percentages and add more variety to the mix with index funds that cover value stocks, growth stocks, commodities, real estate, high yield, big companies, small companies, international, and more. There are many, many more different funds and types of assets out there. I've seen people's portfolio balance recommendations that included 10 or more different investment types!

Which different investments are required to be balanced?

As a beginner, I don't recommend getting too complicated with your portfolio. I suggest keeping it simple. With all the different index funds out there, some of which I listed above, it can be overwhelming to try to make a good balance. However, you can easily cover all your bases with 3 different index funds -- a bond index fund, a US stock index fund, and an international index fund. You will not miss out on any corporate profits by owning just these three funds.

Keeping it simple also keeps you from speculating. For example, many people think gold will be a great investment over the next decade or so because (among other things) they're expecting high inflation due to all the new money the federal government is adding to the economy. Inflation is not that easily predictable. These people are speculating. Not having a gold or commodities index fund would keep you from being tempted to participate in this popular speculation.

What is a good portfolio balance?

This really depends on your age, target retirement date or target date to use the money, and ability to emotionally handle sudden portfolio losses and gains. I think its best to keep it simple.

A common recommendation is your age determines the bond percentage. For example, if you're 40, that means you should put 40% of your assets into bonds and 60% into bonds. This heavy on the bonds side and, therefore, is a conservative balance. I think your age minus 10 for bonds is probably better for most people.

After you determine your stock percentage, I recommend putting 20 to 40% of those stocks into an international stock index fund. This makes you less tied to the financial success of the US. However, as time goes by, we're getting closer to a world economy and I suspect the international and US stock indexes will gradually get more and more correlated.

Or, you could take the easy (and smart for most) way out of figuring out the best asset allocation and just invest in a target retirement fund. This will automatically choose a good balance for when you need the money.

What about when the portfolio percentages change?

Over time your asset allocation will change as the values of the different assets change at different rates due asset correlation. As a result, you will need to sell some of one asset and buy another so that you remain balanced. I recommend doing this either once every 6 months or once a year.

You can find examples of portfolio rebalancing at the bottom of best way to invest money.

Why would I want to rebalance?

You might be thinking, "if the value of an asset increases, shouldn't I buy more of it because its better performing?" No. Absolutely not. You want to do the opposite -- especially with stocks. If you buy more after something has raised, you're practicing "buy high" and not "buy low." Likewise, you'd be "selling low."

If you rebalance your asset allocation percentages, then you are automatically buying low and selling high. For example, lets say my portfolio is set to be 50% stocks and 50% bonds. Stocks then go up to where they are 60% of my portfolio. I will sell down to 50% stocks at a high point and buy back up to 50% bonds at a low point. Then when, stocks fall and are 40% of the portfolio, I will sell bonds at a high point and buy stocks at a low point. You can see the longer term results of these actions in the best way to invest money that I linked above.

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