In this article:
The best investment portfolio is one that's built around your unique goals, risk tolerance and retirement timeline. Your asset allocation is a direct reflection of these things. Finding the right mix of investments can help mitigate risk and position your portfolio for growth. It involves understanding the potential risks and rewards of different asset classes and striking the right balance.
Finding the right asset allocation isn't a static configuration that you set once and leave alone. Instead, your asset allocation will likely change with you as you move through different phases of your life. Rebalancing your portfolio is often necessary along the way, but the idea is always the same—to ensure that your asset allocation is in line with your investment goals. Here are four steps to choosing the right allocation mix for you.
1. Decide On Your Goals
Your investment goals are a driving force when choosing your asset allocation. The idea is to select assets that are most likely to get you where you want to go without exposing you to too much risk.
The first step is identifying what you're working toward. This might include both long-term objectives and goals that are in the not-so-distant future. It'll look different for everyone, but some common investment goals include:
- Growing your retirement nest egg
- Building up your kids' college funds
- Saving for a home down payment
- Setting money aside for home renovations
- Generating startup capital for a new business or career change
When it comes to saving for retirement, your investment horizon will likely be an important factor. Understanding how much you should save by age can help bring this goal into focus.
2. Understand Different Assets Classes
The next step is looking into different asset classes. Think of each one as an umbrella. Underneath are assets you can add to your investment portfolio. They each carry their own risks (more on this in a moment), as well as potential rewards. Below is a breakdown of the three main asset classes:
- Stocks: These are shares of publicly traded companies you can purchase via the stock market. Buying stock gives you an ownership stake in these companies. If prices go up, you can sell your shares for a profit. Buying individual shares is one option, or you can opt for small shares of multiple stocks by way of a mutual fund or exchange-traded fund (ETF).
- Bonds: These are essentially loans. When you buy a bond, you're providing capital to the government agency or company that issued it. You'll then be repaid over time with interest. Bonds are available through brokers, as well as bond mutual funds and ETFs. Treasury and municipal bonds can also be purchased directly from the issuer.
- Cash: Liquidity can be an issue when investing in certain asset classes. If, for instance, you want to pull money from your 401(k), you'll be hit with a 10% penalty if you're younger than 59½. You're also robbing yourself of future investment returns. Keeping cash reserves on hand can cover financial emergencies and provide some guaranteed income in retirement. A high-yield savings account will likely offer the best return.
A word about potential returns: From 2001 to 2020, the S&P 500 produced an average annualized return of 7.5%, according to J.P. Morgan. The average return for bonds was 4.8%. As for cash, a competitive APY for a high-yield savings account is 0.70% at the time of this writing.
Browse Top Brokerages
3. Factor In Your Risk Tolerance
Choosing the right asset mix means accepting a certain level of risk. You'll most likely want to dedicate some portion of your portfolio to stocks—they're often necessary to net the kind of returns you'll need to fuel real growth over time. Stocks are also a primary way of keeping up with inflation.
Bonds are equally important. Returns are lower when compared with stocks, but they're generally seen as safer investments that can provide your portfolio with stability and more reliable income.
Stocks and bonds are sort of like the yin and the yang of your investment portfolio. So how much should you allocate to each? It depends largely on your age. Holding 60% stocks and 40% bonds is one rule of thumb as it's historically offered reliable returns. From 1926 to 2020, the average annual return for this type of portfolio was 9.1%, according to one Vanguard analysis. That said, as you near retirement, it's usually wise to tilt the scales in favor of less risky investments.
Stocks and bonds aside, there's also risk associated with holding too much cash. When your money isn't invested, it isn't working as hard for you as it could. Leaving the bulk of your nest egg in a savings account will likely cut you off from future investment returns and make it difficult to keep up with inflation.
Alternative investments are also worth considering. They stray outside of the three main asset classes and tend to carry a higher level of risk—think cryptocurrency, private equity, hedge funds and real estate. They also have the potential for big returns. Again, it's all a balancing act.
4. Begin Allocating Assets
After exploring different asset classes and understanding the potential risks and returns of each, the task then turns to choosing assets. What you want is a mix of investments that moves you toward your goals while providing balance.
As mentioned earlier, the 60/40 portfolio has long been regarded as a go-to asset allocation—but that doesn't necessarily mean it's right for everyone. Younger folks who are further out from retirement might consider taking on more risk in their portfolio. Their longer time horizon means they have more time to rebound from periods of market volatility. Folks who are approaching retirement, on the other hand, don't have that luxury. A market downturn at this time could majorly eat into their wealth if they have a stock-heavy portfolio.
Deciding on the right asset allocation by age can be tricky. It's certainly possible to do it on your own, but partnering with a qualified financial professional can help take out some of the guesswork. They should be able to make personalized recommendations based on your goals, risk tolerance and time horizon.
Either way, rebalancing your portfolio is generally recommended once per year. As the values of your investments change with regular market activity, your asset allocation could drift away from your target. Rebalancing involves restructuring your portfolio and restoring your desired allocation.
The Bottom Line
Your asset allocation is designed to bring you closer to your financial goals. In truth, it's just one part of financial wellness. Following a budget and keeping up with your credit health are two other core ingredients. They all go hand in hand. Experian can provide the tools you need to maintain strong credit. This includes free credit monitoring to keep you one step ahead of your credit health.