Asset Allocation is your #1 investment decision!
Asset Allocation is the split of your portfolio between stocks and bonds (and other alternative assets like gold or other commodities). Asset Allocation is one of the most important investment decisions you can make affecting the risk and long term return of your portfolio. As a new investor, let’s focus on your portfolio's split between stock (equity) index funds or bonds (fixed income) index funds.
Stocks are shares of a company. Say a company wants to raise money to reinvest in its business by buying new equipment or conducting R&D, the company will sell a share or portion of itself on an exchange like the New York Stock Exchange (NYSE) or NASDAQ. Investors buy the shares of the company giving it funds to invest in its business and the investor gets a “share” of all future profits of the company-either through share price appreciation and/or dividends. The business could succeed in the future and the investor will receive increasing dividend payments or capital appreciation where the share’s price goes up over time. If the business underperforms, or goes bankrupt, investors will lose some or all of their investment.
This makes investing in individual stocks especially risky. However, because of the diversification of mutual funds and ETFs across multiple stocks risk is minimized. In a portfolio of stocks, the loss from bankrupt Lehman Brother shares can be overcome by the appreciation of the Google shares in the same portfolio.
When a company wants to borrow money from investors and not sell a share of its future returns, the company will issue bonds also known as fixed income investments. Bonds are basically loans-a company borrows money from bondholders with the promise to repay the loan at a later date in time for a fixed rate of interest. Often during the loan period, companies will pay a coupon or interest payment to bond holders and at the end of the loan period return all of the bond principle or money originally owed.
Treasury or municipal government bonds and highly rated corporate bonds are typically considered safe investments though risk can never be completely eliminated. Because the risk of high quality bonds is lower, typically bonds have a lower rate of return than stocks (though this is not always the case-there have been periods where bonds outperformed stocks). For bond investors chasing higher yield, poorly rated junk bonds are available for higher returns but also at significantly higher risk.
Stocks returns have outperformed bond returns overtime. However, building a portfolio on a mix of stocks and bonds can lower the risk (losses) of a portfolio.
During the Dot.com crash of the early 2000’s and the Great Recession, investors with a 60%/40% stocks to bonds had lower losses than those with 100% stocks. However, investors with 100% bond portfolios are almost guaranteed to underperform those with some allocation to stocks.
Depending on your appetite for risk and investment time horizon you should set your asset allocation accordingly. If you are going to panic and sell in a downturn-increase the percentage of bonds (though of course as a long term passive investor you won’t sell and will see the downturn as a buying opportunity). And if you’re closer to retirement-within 5-10 years-minimize the percent of stocks in your portfolio to minimize your exposure should the market crash just before you retire.
The investing rule of thumb for percent of stocks in your portfolio is 120 to 100 minus your age. So for a 30 year old today-she should have 90-70% stocks index funds and 10-30% bond index funds in her portfolio. A 60 year old man should have 40-60% bonds in his portfolio as he is near retirement.