Allocating Your Assets
Charles B. Carlson, CFA
Contributing Editor, Dow Theory Forecasts
How much money should you have in stocks? In bonds? In money market accounts? In real estate?
Deciding how much money to have in each asset class is referred to as "asset allocation."
Indeed, the aim of asset allocation is to diversify your portfolio to reduce risk. To reduce risk via asset allocation means to have your assets in areas other than just stocks, such as bonds.
One of the downsides of reducing risk via asset allocation is that you will own asset classes that, over time, have generally not done nearly as well as stocks.
To my way of thinking, a better way to reduce risk is to extend your time horizon. In other words, the risk of holding stocks in a portfolio decreases the longer you are willing to hold stocks. That's because while stock prices can fluctuate a lot in a single year, those fluctuations tend to smooth out over a long period of time.
Thus, the Carlson school of asset allocation says that, if you are willing to invest for 15-20 year time frames, you are better off owning stocks rather than a portfolio of stocks, bonds, and cash. Why? Because history has shown that over such long time frames, stocks beat bonds nearly every time.
Of course, what if you don't have a 15-20 year investment time horizon. Or you need to diversify your investments because you have certain financial obligations to meet in the short term. How should you allocate your assets under those circumstances?
A good rule of thumb is the following: Subtract your age from 110, and that's the amount of your portfolio you should devote to stocks or stock mutual funds. For example, a 50-year old could have 60% of a portfolio (110 minus 50) in stocks or stock mutual funds; the remainder, in bonds and cash.
This rule of thumb may not work for everyone. But it offers a reasonable starting point when determining a proper asset allocation.
Keep in mind, however, that if that 50 year old is truly committed to owning stocks for 15-20 years (and doesn't anticipate a need for the money), I might argue that having 100% in stocks is acceptable for a more aggressive investor.
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