Asset allocation refers to the combination or range of investments you hold in a portfolio. It is one of the most basic investment terms to know and also one of the most important. Choosing the best asset mix for your needs can make the difference when it comes to achieving your long-term financial goals. There are different ways to go about building an investment portfolio, and your choice of assets can depend largely on your age, tolerance for risk, and what you hope to achieve. Understanding the different options can help you decide on the best asset allocation for your needs.
The choices available to investors when looking for the best asset allocation are vast, so working with a financial advisor to get the right mix can really pay off.
Definition of asset allocation
Asset allocation simply means how you allocate the assets in a portfolio. In other words, this is what you invest in. For example, some of the more common assets include stocks, bonds, mutual funds, and real estate.
The asset allocation of a portfolio is not the same as the location of its assets. Asset location refers to where you hold your assets. So, for example, this could include holding investments in a 401 (k) plan at work, in an individual retirement account (IRA), or in a taxable brokerage account.
Why is asset allocation important? For one important reason: diversification. When you diversify your investments, you spread the risk. So if some of your investments underperform or are impacted by market volatility, you have other investments to balance them out.
Asset allocation models
When it comes to the best asset allocation, there is no one-size-fits-all option. Again, what you choose can be based on your investment goals or objectives, your time horizon for investing, the level of risk you are comfortable with, and the risk you need to take to achieve your goals. If you’re new to asset allocation, it helps to understand some of the more basic models.
The 60/40 portfolio dictates a simple allocation of your assets: 60% for stocks and 40% for bonds. This asset allocation is simple to apply and understand, which may appeal to investors who prefer a more passive approach. You have a chance to generate stable returns from the equity portion of the portfolio, but you have a significant number of bonds to balance that out.
The downside, of course, is that a 60/40 portfolio may not be suitable for people who have a higher tolerance for risk. If you’re investing in your 20s, for example, you have more time to recover from market fluctuations and can generally take more risk. And if you do, you could be rewarded with higher returns.
An 80/20 asset allocation is similar to the 60/40 portfolio. But instead of owning 60% of your assets in stocks, you increase that to 80%. This portfolio model involves more risk since you own a greater proportion of stocks. But you might enjoy better returns over time.
Asset allocation by age
Age asset allocations use your age as a guideline for deciding how much to allocate to stocks versus bonds. For example, there is the rule of 110. This rule says to subtract your age from 110 and then use that number as a guideline for investing in stocks.
So if you are 30, you will be investing 80% of your portfolio in stocks (110 – 30 = 80). However, the rule of 110 is increasingly giving way to the rule of 120 as investors live longer. With this rule, you are using 120 instead of 110. Again, if you are 30, you will be investing 90% of your assets in stocks (120 – 30 = 90).
The asset allocation by age is fairly straightforward to apply. But it’s important to determine whether using this type of rule matches your investment goals and the level of risk you’re comfortable taking.
100% asset allocation
Another option for the best asset allocation is to use the 100% rule and build a portfolio made up of either stocks or bonds. This rule gives you a choice of two extremes: high risk / high returns or low risk / low returns. Whether it makes sense to bet stocks or bonds can depend on what you are trying to do with your portfolio. If you’re 25 and still have 40 years to invest, for example, you can’t panic about investing all of your money in stocks.
On the other hand, if you are 65 or older, it may be a good idea to focus your money more on bonds and similar fixed income investments.
3 fund portfolio
A three-fund portfolio is another asset allocation model that makes things easier. With this type of asset allocation, you build your portfolio around three funds. Typically, this means investing in each of the following:
An American stock index fund
An international stock index fund
An index fund for the US bond market
The idea behind the 3 fund approach is that you can use three funds to cover all of your investment bases to maximize returns and minimize risk. Index funds track the performance of an underlying benchmark, such as the S&P 500. So, assuming you choose index funds that track a reliable benchmark, you may be able to count on consistent returns. over time.
Target date fund allocation
Target date funds have an asset allocation based on your target retirement date. As you approach retirement, these funds automatically rebalance to manage risk.
If you have a 401 (k), there’s a good chance you’ve invested in at least one target date fund, as these investments are very popular with working plans. The advantage is that these funds are established and forget about it. All you have to do is choose the one that is closest to your target retirement date.
But in terms of performance, target date funds may not allow enough risk to be taken to generate the returns you are looking for. And some of them may incur high fees.
A final way to allocate assets is to look at your goals. For example, if you are a young investor, you might be primarily interested in growth. So you could invest assets in growth stocks, growth mutual funds or growth exchange traded funds (ETFs). On the flip side, if your focus is more on income, you might turn to stocks, bonds or bond funds and ETFs that pay dividends.
A third option is to split the difference and choose a balanced approach. So, going back to previous asset allocation models, you can choose a 60/40 portfolio or even a 50/50 split between stocks and bonds.
How to choose the best asset allocation
Finding the best asset allocation comes down to knowing yourself as an investor and knowing what you need to do for your portfolio. Again, consider things like:
How much time you need to invest
What level of risk you are comfortable with
Your final goals for investing
How much risk you need to take to achieve your goals
Where you plan to hold different investments
Also consider the costs involved. For example, if you invest in mutual funds or ETFs, it is important to check the expense ratios. This is what you will pay to hold the fund on an annual basis. Over time, expense ratios can eat away at the returns on your investments.
If you trade individual stocks or ETFs on a brokerage account, look for one that does not charge any commission for those trades. More and more online brokerage houses have adopted a no-commission model, but some still charge a fee.
Finally, remember that your asset allocation is not set in stone. As you age and move through different stages of life, your needs and goals may change. It is therefore important to review your portfolio asset allocation at least once a year to ensure that you are always on track with where you want and need to be.
The bottom line
Choosing the best asset allocation is essential for maximizing returns and minimizing risk when investing. If you don’t get the right mix, you might miss out on some opportunities to earn returns. Or, you could take too much risk and end up wasting your savings without having enough time to get them back. It’s a decision you can’t afford to ignore or delay. The sooner you start to tailor your portfolio to your specific needs, the sooner you can get on your way to meeting your investment goals and building wealth.
Tips for investing
Consider speaking with a financial advisor to find out how to choose the best asset mix for your needs. Finding a qualified financial advisor doesn’t have to be difficult. SmartAsset’s free tool connects you with up to three financial advisors in your area, and you can interview your correspondents free of charge to decide which one is best for you. If you’re ready to find an advisor, start now.
Be sure to use the free SmartAsset Asset Allocation Calculator to focus on the allocation that’s right for you.
When considering the location of your assets, keep in mind that some investments tend to be more tax efficient than others. For example, passive ETFs tend to have a lower turnover rate than active mutual funds. This means fewer capital gains tax events. So when deciding where to keep your investments, you can put passive ETFs in a taxable brokerage account and save the actively managed funds for your 401 (k) or IRA.
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The publication What is the best asset allocation for my needs? first appeared on the SmartAsset blog.