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How to Determine Your Asset Allocation

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Gold Bars and Some CoinsAsset allocation is probably one of the hardest parts about investing because while we all know it’s important, we don’t really know what we’re supposed to do. We know that diversification is crucial but we aren’t entirely sure why outside of “don’t put all your eggs in one basket.” Fortunately, there are some simple systems out there that can shed some light onto the asset allocation question.

This post is part of the Bargaineering Annual Financial Review week series where we take a closer look at the four major facets of personal finance and see if we can do better. This post is part of day three – taking a closer look at your investments.

SEC’s Guide to Asset Allocation

The first thing you should do is read what the SEC has to say about asset allocation and diversification. The page doesn’t have any big revelations but it does give you a basic understanding of the importance of proper asset allocation, why you need to diversify, and how you need to revisit these issues at least once annually to rebalance.

The guide itself doesn’t talk about specific allocations. It says you need to establish your goals, think about your time horizon and risk tolerance, then pick investments that have the best chance of getting you there. They are very general when it comes to discussing asset classes (stocks, bonds, cash) and avoid making any specific recommendations. They do point to an Asset Allocator calculator by the Iowa Public Employees Retirement system.

This post is part of the Bargaineering Annual Financial Review week series where we take a closer look at the four major facets of personal finance and see if we can do better. This post is part of day three – taking a closer look at your investments.

The big takeaway from all this is that regardless of what you decide for your asset allocation, the most important thing is that you actively make the decision. Don’t just accept your 401k’s default allocation, make an educated decision and you will be much better off.

So, in light of that, let’s talk about some common allocations.

Lazy Portfolios

Lazy portfolios aren’t portfolios that lack pep in their step, they’re portfolios designed for the investor who doesn’t want to spend too much time analyzing and allocating. The lazy investor, if you will.

There are several lazy portfolios but the classic “couch potato” portfolio is a 50% allocation in the Vanguard 500 Index Fund (VFINX) and a 50% allocation in the Vanguard Total Bond Fund Index Fund (VBMFX). The idea is that you want something simple, you know Vanguard funds are cheap (and it takes just a few seconds to confirm this), so why not set an allocation like 50-50, set it and forget it?

The risk is that while setting an allocation is better than taking what your plan gives you, you haven’t actually made an active decision based on your goals. You simply chose a plan that has gotten some ink in the papers. Of course, keeping things simple means you’re more likely to stay on top of it (it’s easy to rebalance a portfolio of two assets!) so being lazy does have its merits.

120 Minus Age

This is a classic investment rule of thumb. You should take 120, subtract your age, and put that percentage of your retirement assets in stocks. The rest should be in bonds. So if you’re 20, all of your investments should be in stocks and none should be in bonds. As you age, the asset allocation adjusts from risky (stocks) to safety (bonds).

While it’s better than settling for the default, this rule may be riskier than you are willing to stomach. It also almost too basic a rule because it only sets allocation between stocks and bonds. There’s no discussion of what kind of stocks (domestic vs. international, large cap vs. small cap, etc.) and its one-dimensional nature seems to be its downfall. Of the three “easy” approaches, this one is probably the weakest.

Target Retirement Funds

Target Retirement funds, made popular in the last five years or so, are mutual funds that adjust their holdings as the years pass. Also known as Lifecycle and Target Date funds, they are typically named with a target “year.” So a Target Retirement 2040 fund is designed for someone looking to retire in 2040. They invest in a mix of assets with the mix becoming more conservative as the target retirement date draws closer.

Target retirement funds are easy because they set the allocation for you but they can cause you to become complacent. Since you don’t have to rebalance, the fund takes care of that for you, you may forget to rebalance your other assets. In fact, target retirement funds work best when you invest all of your retirement in the funds. If you don’t, your other assets throw your allocation out of alignment since the funds assume 100% of your assets are in that fund. Again, it’s an easy solution that’s better than nothing, but nothing beats careful planning.

I’ve offered up three different options, none of which are ideal but all of them are better than sticking to your 401(k) default allocation. It’s up to you to decide which one works best for you because there’s no magic allocation that will always work for everyone, as this last year’s stock market performance has shown. In the end, it’s about creating a plan and sticking to the plan. If things go awry, they go awry, but at least it was because of careful planning and not haphazard guessing (sometimes, it’s the best you can do).

If you have any recommendations on how to set an asset allocation, what you do to help planning, please let us know because I think most people have difficulty with this topic.

(Photo: bullionvault)

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27 Responses to “How to Determine Your Asset Allocation”

  1. jsbrendog says:

    ive got my target date fund and 401(K). i set up the 401k similar to the tdf so that they grow in conjunction and then once i actually have some money in the 401k, or move to a better company, i will probably move out of the target date fund but it is a great start, especially for someone young like me hwo didnt know a damn thing about any of this a yr ago when i started researching it all

  2. Chris says:

    Rebalancing would have saved millions for many retirees over the last few years. I like the idea of target funds for their simplicity.

  3. RJ Weiss says:

    Many people use asset allocation and diversification interchangeably, which makes the 120 minus your age rule confusing. I have always considered asset allocation to be how much you allocate between stocks and bonds and diversification as choosing what stocks and bonds to allocate.

    Unfortunately, not everyone is on the same page as me, which makes the 120 statement very misleading.

    • Anthony says:

      Asset allocation and diversification are very similiar topics and are closely tied to each other.

      “Diversification” is simply an idea that focuses on putting your money into several different places. That’s all it is. “Diversifying” does not identify which stocks/bonds or how much into these stocks/bonds. Again, it’s an idea that spread is spread across multiple funds.

      “Asset allocation” is how much money and into which stocks/bonds.

      I’m not an expert, but I hope this makes it a little clearer. You basically “diversify” by “allocating your assets” appropriately.

      • NateUVM says:

        Diversification isn’t limited to just spreading your investment within the same asset class (a bunch of stocks from separate issuers vs. a bunch of stocks from one). Diversification can be acheived by spreading your investment over a bunch of different asset classes, within investments with different maturity dates, and with varying risks.

        For instance, one way of diversifying that not many people realize is to invest in several CDs with different term lengths (similar, but not identical to a ladder). It’s all in the same asset class…heck, it’s all in the same basic investment, but it’s still diversifying.

        In the case of Asset Allocation, what we are talking about is simply another form of diversification. You are spreading your investment amongst different asset classes, mitigating risk, by limiting your exposure to any one asset class.

        Diversification isn’t limited to Asset Allocation, but Asset Allocation is a form of Diversification.

  4. Because most people have careers, homes, families, hobbies, etc, the idea of a lazy porfolio is more appealing than it seems on the surface.

    There’s a big emotional component to investing and it would serve well to have a “fire and forget” allocation, if that’s possible, freeing us up to take care of other matters.

    Of course, it would have to be more on the conservative side so it wouldn’t have to be monitored continously.

    Didn’t this used to be called “widows and orphans” investments?

  5. Anthony says:

    My wife is using a target fund for her 403(b): It is performing great! YTD, it’s outperforming my personal mix of stocks/bonds. It’s no-hassle and the expense ratio is low. It’s a good fund for her.

    I can agree with your statement that none of these 3 ideas are “ideal.” I’d assume here that “ideal” means taking into account your level of tolerance for risk and identifying your own funds. However, whether using a target fund or your own personal mix, that still doesn’t guarantee one will perform better than the other.

  6. eric says:

    I’ve helped out a lot of friends and close ones with their asset allocations because most of them had no idea what they were choosing in their 401ks. One of them even said they just randomly picked one on this list…not a good idea!

    • jsbrendog says:

      haha wow. yeah i am going to guess that randomly picking a fund for your 401k is NOT the way to play it. it is like guidance counselor’s throwing gum at a board of professions when trying to judge what your future may hold hahaha

  7. redivelli says:

    First off, kudos to this article. I have been researching this particular thing quite a bit lately.

    Target date funds are nice for those who are complacent. I think they will become even more predominant if the government is able to regulate them.

    One thing I would like to mention is diversification of taxable accounts. Taxes will hurt your returns just like expense ratios. I’m sure others know more about this than me, but I will explain the gist of what I know. Bonds are eventually taxed a different way than stocks. Stocks held for a year+ are taxed differently than those bought and sold often. I think that bonds are better to be held in accounts such as your Roth, while stocks are better for your brokerage accounts and 401k.

    ~Red

  8. zapeta says:

    I think an important thing to remember is to not drive yourself crazy thinking about your allocation. For someone who is starting out, pick a lazy portfolio or a target fund and invest now rather than later. You can do additional research later to figure out what the best allocation for you might be but you can’t get years of investment growth back.

    • Zapeta–that’s a really outstanding point. The right time never comes, and most of us are loathe to admit that we really don’t have the investment savvy we wish we had.

      The best approach is to take the simplest route (without placing all of our money at risk), and let time do it’s work.

      • saladdin says:

        The key is to put money away. 100 people have different allocations and will end up with different amounts of money but I guarantee none of the 100 regret saving.

        saladdin

  9. Diversify is the safest I agree, but even the experts got wiped out recently.

    John DeFlumeri Jr

    • saladdin says:

      I don’t know what you mean by “wiped out.” I lost 40% last year but was not wiped out. I am up 40% this year. I know that doesn’t put me even but that’s far from wiped out.

      saladdin

    • Jim says:

      The stock market is volatile and everyone knows it, you don’t have to invest in the stock market… in fact, you don’t have to invest at all. If you do, you need to take steps to protect yourself.

      It’s like driving. Driving is dangerous but you take steps to protect yourself like wearing a seatbelt.

  10. aua868s says:

    index funds help me be an “investor” without getting my hands dirty on scouring through wall street journal, barrons and like…

  11. Izalot says:

    I use the 120-age rule then for the stock portion I divide it into the following:

    Large caps-25%
    Mid caps-25%
    Small caps-15%
    Foreign-25% (12.5% Euro and 12.5% Emerging market)
    Real Estate-10%

    I’m very limited in what mutual funds I can get through my retirement plan, but in the broad categories I laid out I choose the ones with the smallest service fees.

    I also re balance my portfolio 1-3 times a year.

  12. Manshu says:

    I feel Target Retirement Funds are a waste of time if you are buying something else with them. Because then your whole portfolio needs to be balanced with this new allocation, which defeats the original purpose.

    • saladdin says:

      Why don’t you just adjust your “new” fund instead of worrying about the target fund?

      And calling them a waste of time is silly. They have a purpose, a very good purpose. It’s not like if I invest in only 2 funds, a target fund and an emerging fund out of Brazil, that I will never be able to retire.

      saladdin

    • NateUVM says:

      More to saladdin’s point, I don’t think it’s a big deal to add another fund into the mix with a Target-Date fund. Of course…I am biased, because that is exactly what I have done with my 401(k).

      I liked the idea of a pre-set allocation all rolled up into one fund, but even the most aggressive Target-Date funds (and as my planned retirement is still a ways off, I’m already in the most aggressive category) didn’t have a large enough allocation to foreign markets.

      So, I looked at what % of the Target-Date fund was invested internationally, figured out how much more would need to be invested to meet my desired allocation, and tacked on an international fund with that %. Rebalance quarterly, and I’m all set… My own custom portfolio. Until, of course, I get to a point where I want to be less aggressive. But that is a ways down the line, and I don’t mind setting it in what I have it in now and forgetting it (thanks Ron Popeil).

      Let’s not also forget to mention that Target-Date funds tend to have lower expenses due to their being mostly indexed and not actively managed. More $$$ in the bank.

  13. Finavigation says:

    In my opinion, asset allocation is one of (if not the) most important thing in determining what type of returns you end up getting from your portfolio. It’s one of the “big things” you can do right that you’ll be glad you did down the road.

    Something about diversification that some people don’t understand is that you’re not necessarily diversified just because you invest in different mutual funds.

    An important part of diversification is investing in assets whose performances aren’t correlated. In other words, when one performs poorly, the others aren’t likely to do the same.

    If you’re buying a few different funds but those funds are invested in many of the same stocks, then you’re probably not sufficiently diversified and may be exposing yourself to excess risk if those holdings perform poorly.

    Additionally, you may be sacrificing some good returns in other uncorrelated funds.

  14. DIY Investor says:

    Asset allocation is about your basic split between stocks and bonds. Within stocks and bonds there are various sectors.Investing in these sectors gives you diversification. For example there are big cap stocks and small cap stocks. There are value stocks and growth stocks. If you aren’t participating in these sectors you are not well diversified. If you invest only in the S&P 500 you are in just one corner of the stock market.
    The same holds with bonds. There are various parts of the bond market and to be well diversified means to participate in these sectors.
    With target date funds it is worth noting that if you go to 5 different brokerages you will get 5 different allocations. If you are willing to let your risk tolerance be set by a cookie cutter approach then go for it. There are tools on line for others to help with risk tolerance.


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