This is a guest post from Jarrad – the editor of the Kyoto JET blog, Ganbatte Times. Jarrad got started with his finances about a year ago and agreed to share his thoughts about asset allocation for the FF readers. This post is a little advanced, but introduces some financial information that you’ll start thinking about as you your cash reserves grow.
Asset allocation is perhaps the single most important investment decision that you will need to make. Fortunately, you only need to make the decision once and then ride
it out for the next 30+ years. In fact, changing your asset allocation is far more likely to be harmful than helpful.
So, why is asset allocation important? Generally, when you increase your risk, you also increase your potential for return. That is, if you want to make a higher return, you have to take greater risks. However, if done right, proper asset allocation can achieve both greater return and reduced risk.
When I initially started investing, deciding on my asset allocation was by far the most challenging decision I had to make. In its simplest form, it consists of simply making the decision about how many of your investment dollars will go to bonds and how many to stocks. However, the advice on even that relatively simple decision varies greatly.
Simplifying Asset Allocation
If you are a conservative investor who is willing (and able) to accept a lower return in order to take as little risk as possible, then your age is your bond allocation. Merely subtract your age from 100% and voila, you have your stock allocation. For example, if you are 25 years old, you will invest 25% in bonds and 75% in stock. If you are the risk pursuing type, you can subtract your age from as much as 125%, which translates to 100% stock allocation.
Naturally, if you are in your 30s or 40s and just now starting to invest, you will need to put a larger percentage of your income into investing or take greater risks in order to make up the money you lost by waiting. However, for reasons far outside the scope of this article, you should allocate at least some to bonds because an allocation of up to 10% can actually reduce your risk while also increasing your return. For the same reason, you will always want at least some of your investment dollars in stocks.
As a side note, your stock-bond allocation is the one aspect of your asset allocation that will change over the years. The rule of thumb is that you increase your bond allocation by 1% each year. This can be accomplished in two ways: (1) by putting your new investment dollars into bonds or (2) shifting high performing assets into bonds during annual (or biennial) rebalancing.
Asset Allocation Choices
As I said before, your stock-bond allocation will be your easiest allocation decision. If you decide to go with a total market fund and a total bond market fund, you could theoretically call it quits after making this allocation. However, if you want to continue reducing your risk while increasing your return, you will need to make additional allocation decisions. Here is a list of at least some of those decisions:
- Stocks vs. Bonds
- Growth vs. value stocks
- Government bonds vs. corporate bonds
- U.S. vs. international stocks
- Bonds vs. treasuries vs. t-bills
- Pacific vs. European vs. emerging market stocks
- Investment grade vs. junk
- Large cap vs. mid-cap vs. small cap stocks
Naturally, you can add commodities or other sector specific stocks, as well. However, when you start investing in those areas, you may be venturing out of investment and into speculation.
A great thing about asset allocation is that it can be as simple or as complicated as you want it to be. The best part about it is that asset allocation will allow your investments to ride out many of the ups and downs of the market because, for example, while U.S. stocks are suffering, U.S. bonds are usually flourishing.
In the future, I’ll try to put together some information about your different allocation options. In the meantime, do some research and figure out your stock-bond allocation.
Thanks to Jarrad for the post and make sure to check out his site, Ganbatte Times.
Photo: blprnt
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Great post! I’ve been finding it difficult to figure out just how much I should have in the stock market (higher risk), in bonds (lower risk), in savings (no risk) — right now, Its largely all in the stock market… something that I need to change!
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I’ll take issue with the phrase “Asset allocation is perhaps the single most important investment decision that you will need to make”.
The most important decision is your savings rate. Asset allocation won’t help a lick if you aren’t saving an overall 25%+ (including the governments 10% social security on your behalf). Anything less often leaves you trying to chase a riskier AA than you have the guts to handle. — or even worse, fall in with Madoff scam artists.
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Steven J Fromm Reply:
May 19th, 2013 at 12:40 am
Great point MossyFS; you must have some girth to your investment dollars to have any of this make sense.
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Great intro post man! Every should diversify their portfolios!
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With the economy still rocky it seems everyone is posting about investing and sharing money tweets but this is a great article. It really explains the risk vs. reward well. Thanks for sharing!
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It’s good to start out conservative until you build confidence with your funds so I like the age rule for asset allocation.
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Great post! I agree that you have to allocate your assets, but I do it differently (as in I don’t include bonds). Mostly among stocks, commodities, and currencies – 3 assets that are inverse to each other.
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Great post. I never heard of the 125% rule for aggressive investors. So an aggressive 62 year old investor would have 63% invested in the stock market and the rest in fixed income investments and cash. Not a bad plan.
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Great post. I never heard of the 125% rule for aggressive investors. So an aggressive 62 year old investor would have 63% invested in the stock market and the rest in fixed income investments and cash. Not a bad plan.
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