Asset allocation is one of the most important factors in your success as a long-term investor according to many financial experts. It’s a hundred times more important than any stock pick and more important than knowing the next hot country to invest in… what option to buy… what the housing market is doing… or whether the economy is booming or busting.
Asset allocation is how you balance your wealth among stocks, bonds, cash, real estate, commodities, and precious metals in your portfolio. This mix is the most important factor in your retirement investing success.
Ignorance of this topic has ruined more investment and retirement portfolios than any other financial factor. Many investors have no clue on what a sensible asset allocation should be. So they end up taking huge risks by sticking big chunks of their portfolios into just one or two investment assets.
For example, people who had most of her wealth in real estate investments in 2008 experienced significant losses when the market busted in 2009. Or consider employees of big companies that put a huge portion of their net worth or retirement money into their company stock. Employees of big companies that went bankrupt, like Enron, WorldCom, Bear Stearns, and Lehman Brothers were totally wiped out. They believed in the companies they worked for, so they kept more than half of their retirement portfolios into company stock.
And it’s all because they didn’t know about proper asset allocation. Because of this ignorance, they lost everything. These examples demonstrate why asset allocation is so important because keeping your wealth stored in a good, diversified mix of assets is the key to avoiding catastrophic losses.
If you keep too much wealth – like 90% to 100% of it – in a handful of stocks and the stock market goes south, you’ll suffer badly. The same goes for any asset… gold, oil, bonds, real estate, or blue-chip stocks. Concentrating your retirement nest egg in just a few different asset classes is way too risky. Betting on just one horse or putting your eggs in a single asset basket is a fool’s game.
Spread your risk around.
A sensible asset mix should include five broad categories… cash, stocks, bonds, real estate, and precious metals. And, a favorite asset of all long-term investors should be cash. “Cash” simply means all the money you have in savings, checking accounts, certificates of deposit (CDs), and U.S. Treasury bills. Anything with less than one year to maturity should be considered cash.
It’s best to keep plenty of cash on hand so you can be ready to buy bargains in case of a market collapse. Investors flush with cash are often able to get assets on the cheap after a collapse – they can swoop in and pick things up with cash quickly, and often at great prices.
Generally, it’s recommended to hold between 10% and 15% of your assets in cash, depending on your circumstances. In fact, one of the major tenets of good financial planning is to always have at least 6 to 12 months of essential living expenses in cash in case of disaster. If you haven’t started saving yet, this is the No. 1 thing to start today.
Next, you have conventional equity stocks. These are investments in individual businesses, or investments in broad baskets of stocks, like mutual funds and exchange-traded funds (ETFs). Stocks are a proven long-term builder of wealth, so almost everyone should own some. But keep in mind, stocks are typically more volatile than most other assets.
Just like you should stay diversified overall with your assets, you should stay diversified in your stock portfolio. Once, a well-known TV money show host ask callers: “Are you diversified?” According to him, owning five stocks in different sectors makes you diversified. This is simply not true. It is a dangerous notion.
The famous economist Harry Markowitz modeled math, physics, and stock-picking to win a Nobel Prize for the work on diversification. The science showed you need around 12-18 stocks to be fully diversified.
Holding and following that many stocks might seem daunting – it’s really not. The problem is easily solved with a mutual fund that holds dozens of stocks, which of course makes you officially diversified.
Next you have fixed income securities, with are generally called “notes” or “bonds.” These are basically any instrument that pays out a regular stream of income over a fixed period of time. At the end, you also get your initial investment – which is called your “principal” – back.
Depending on your age and tolerance for risk, bonds sit somewhere between boring and a godsend. The promise of interest payments and an almost certain return of capital at a certain fixed rate for a long period of time always lets me sleep well at night.
Adding safe fixed-income bonds to your portfolio is a simple way to stabilize your investment returns over time. For people with enough capital, locking up extra money (more than 12 months of your expenses) in bonds is a simple way to generate more income than a savings account.
Another asset class is real estate. Everyone knows what this is, so we don’t need to spend much time covering this. If you can keep a portion of wealth in a paid-for home, and possibly some income-producing real estate like a rental property or a farm, it’s a great diversifier.
Precious metals, like gold and silver, an important piece of a sensible asset allocation
Precious metals, like gold and silver, are like insurance. Precious metals like gold and silver typically soar during times of economic turmoil, so it’s wise to own some “just in case.” Avoid the mindset of the standard owner of gold and silver, who almost always believes the world is headed for hell in a hand basket. You should remain an optimist, but also a realist and own insurance. Stay “hedged.”
For many years, the goal with hedging strategies was to protect wealth and profits from unforeseen events. Wealthy people almost always own plenty of hedges and insurance. They consider what could happen in worst-case scenarios and take steps to protect themselves. Poor people tend to live with “blinders” on.
So just like wearing a seat belt while driving or riding in a vehicle, it’s important to own silver and gold – just in case. For most people, most of the time, keeping around 3% to 5% of your wealth in gold and silver provides that insurance.
Asset allocation guidelines
There’s no “one size fits all” asset allocation. Everyone’s financial situation is different. Asset allocation advice that will work for one person, can be worthless for another.
But most of us have the same basic goals: Wealth preservation… creating safe consistent income… and safely growing our nest egg. We can all use some guidelines to help make the right individual choices. Keep in mind, what I’m about to say are just guidelines…
If you’re having a hard time finding great bargains in stocks and bonds, I think an allocation of 15%… even 20% in cash is a good idea.
This sounds crazy to some people, but if you can’t find great investment bargains, there’s nothing wrong with sitting in cash, earning a little interest, and being patient. If great bargains present themselves, like they did in early 2009, you can lower your cash balance and plow it into stocks and bonds.
As for stocks, if you’re younger and more comfortable with the volatility involved in stocks, you can keep a stock exposure to somewhere around 65%-80% of your portfolio. A young person who can place a sizable chunk of money into a group of high-quality, dividend-paying stocks and hold them for decades will grow very wealthy.
If you’re older and can’t stand risk or volatility, consider keeping a huge chunk of your wealth in cash and bonds… like a 25%-35% weighting. Near the end of your career as an investor, you’re more concerned with preserving wealth and keeping up with inflation than growing it, so you want to be very conservative.
As a guideline, the big thing to keep in mind with asset allocation is that you’ve got to find a mix that is right for you… that suits your risk tolerance… your station in life. Whatever mix you choose, just make sure you’re not overexposed to an unforeseen crash in one particular asset class. This will ensure a long and profitable investment career.
In summary, asset allocation is how you balance your wealth or net worth assets among stocks, bonds, cash, real estate, commodities, and precious metals in your portfolio. It is the single most important factor in your success as an investor.
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David Bach is a financial expert and bestselling financial author. He has written ten consecutive New York Times bestsellers with more than seven million books in print, translated in over 19 languages.
