What’s the Point of Asset Allocation?
The main idea behind proper asset allocation is maximizing your portfolio’s return while minimizing your risk. While maximizing returns seems clear, risk is subjective and differs person to person. Everyone has their own risk tolerance based on a variety of factors, so you’ll see different investors choose different investment vehicles even if they are the same age.
A benefit of having the proper asset allocation is to fit your goals. Usually investors seek aggressive growth in the long term and shift to more stability of their money in the short term (i.e. for people retiring soon).
Looking at Target Mutual Funds
To give you an idea of possible asset allocations, I use Vanguard’s guidelines for their target mutual funds. Vanguard has earned a reputation for good performance and customer service and I know several people in my family who enjoy investing with them. These guidelines are just rules of thumbs, not to be used as a definitive answer to your investing needs.
I’m not going to list all of the funds, just a few to give you an idea of how your portfolio should shift as you age. With stock and bonds listed in the examples below, I would suggest looking at index funds to reduce costs instead of hunting of individual stocks and bonds to put your money in.
If you’re more aggressive, you may want to include some specific stocks that pay a dividend in your portfolio. What is a dividend? It’s money a corporation pays shareholders after taxes. In addition to having your stock increase in value you also can receive additional payments. You can decide what you want to do with that money.
Retirement is usually in the back of many people’s mind as they are just starting off their careers. However, investing early can have a tremendous impact on your portfolio and you can use compound interest in your favor.
Here’s Vanguard’s 2055 fund‘s breakdown:
- 90% Stocks
- 10% Bonds
As one becomes more established in their careers it would be a great time to ratchet up contribution amounts as they receive raises. For instance if you started with a 3% or 5% contribution, could you raise it up to 5% or 10%? Hopefully you won’t notice a bigger chunk going towards retirement because it’s automatically deducted from your higher salary.
Here’s Vanguard’s 2045 fund‘s breakdown:
- 89.67% Stocks
- 10.15% Bonds
- 0.18% Short Term Reserves
You still have decades before you retire, so don’t jump into conservative investments like bonds quite yet.
If you haven’t eliminated your non-mortgage debt, you could be hurting your retirement funding. Your monthly budget could be squeezed and you may be tempted to put off increasing your contributions. If so, get on a debt reduction plan like the Total Money Makeover or do your own debt snowball.
If you’re in a sound financial state and either have only have mortgage debt or no debt, then consider maximizing your annual contributions to take advantage of employer matches and tax breaks.
Here’s Vanguard’s 2035 fund‘s breakdown:
- 88.68% Stocks
- 11.22% Bonds
- 0.10% Short Term Reserves
Hopefully by this time you’ve become accustom to contributing 10-15% of your monthly income for your upcoming retirement. If not, now is the time to get serious about your monthly budget and including enough to set aside for your upcoming retirement.
Here’s Vanguard’s 2025 fund‘s breakdown:
- 73.60% Stocks
- 26.29% Bonds
- 0.11% Short Term Reserves
My Own IRA’s Asset Allocation Model
In case you’re curious, I’ll share my own IRA plans for asset allocation. I based mine on David Swensen’s model. Swensen has had a long track record of solid returns at Yale. The general asset allocation Swensen recommends includes:
- Domestic Equity (30 percent)
- Real Estate Investment Trusts (20 percent)
- Foreign Developed Equity (15 percent)
- U.S. Treasury Notes and Bonds (15 percent)
- Emerging Market Equity (5 percent)
- U.S. Treasury Inflation-Protection Securities (TIPS) (15 percent)
Since I have decades before I expect to draw money from this account, I don’t really have much in the way of bonds and the more conservative investments. (Clarification due to reader comment – I’m working toward the Swensen model, but currently have more invested in foreign developed equity and emerging markets than Swensen suggested. As I continue with contribution I’ll add more conservative investments. )
I use a combination of index funds and exchange traded funds. If you’re looking at this model for yourself, Get Rich Slowly has some index funds and ETFs that you can build with.
Asset Allocation Based on Age for Retirement
How are preparing your retirement fund in terms of asset allocation? Is there a particular model that you’re following? What have been your returns over the past 5, 10, or 20 years?
Remember these are only guidelines and you may decide to invest more aggressively or conservatively based on different factors, including your own risk tolerance. I’m not a financial professional, so if you’re looking for a professional trained to help with your finances and you live in the United States, try using The National Association of Personal Financial Advisors (NAPFA) to find a fee based financial planner. They should be able to work with you and your individual financial situation.
Photo Credit: Tomitheos