Asset Allocation
The asset allocation of a portfolio is simply the mix of various asset types (or investments) in that portfolio. For example, stocks, bonds, real estate, cash annuity and so on. We know from history that no single asset performs best all the time. We also know that there is a low correlation between different asset types such as bonds and stocks. In some years bonds beat stock and vise versa. Over a very long time, 20 or more years, stocks have in the past performed better than bonds and much better than cash. But, during the 2008 financial crisis the reverse was true. Cash and bonds outperformed stocks. As a general rule on investment allocation, the shorter the period of investment the less risk (and potential return) the allocation should have.
Your asset allocation should be based on your risk tolerance and the time you have to invest. If you have 20 years or more to invest then keeping 55 to 70% in equities (stocks) is not unreasonable. The remainder can be in bonds. This may not work for all investors. The important thing is to keep in mind that a long period of time blunts volatility significantly reducing the risk associated with stocks.
Other factors should play a role in your asset allocation decision. Decide whether your job or business (assuming you own your own business) is like a stock or a bond. Ask yourself if your income is dependable like that of a college professor. Or is it like that of a fisherman, highly variable. If your business or job is like a stock than reduce your stock allocation 5 or 15% or more if your tolerance for risk is very low.
Keep about eight to ten thousand dollars in cash for emergencies. You can keep less if you know that your relatives can and will help you in an emergency.
Once you have decided how much to hold in stocks, bonds and cash go to the next level. Diversify your stock holdings by geography (domestic vs. foreign), style (growth and value), and capitalization size. Buy your stocks primarily by buying mutual funds (see the mutual fund section). If you feel strongly about a specific company and you would like to buy the stock do so after you have done your homework. There is a great deal you need to know. Start by getting a paid membership to Morningstar and reading the stock’s report. Avoid keeping more than 5% of your portfolio in a single stock unless you are willing to do the kind of homework that Warren Buffet does. The simplest approach that gives you instant diversification to the global stock market is a global index fund like Vanguard Total World Stock Index (VTWSX) or the ETF version Total World Stock (VT). Either of these funds will give you instant exposure and diversification to the entire global stock market.
Buy bond mutual funds to get bond diversification. Read the bond mutual fund section to help you choose the right funds for your needs. If you want to keep it simple the PIMCO Total Return D (PTTDX) is hard to beat.
Some mutual funds give you instant diversification they are know as "balanced funds." Most of these funds hold stocks, bonds, and some times other asset types like commodities or precious metals.
Conclusion
The asset allocation decision should be the frist step in your investment decision. To decide on the right mix of assets consider the duration of the investment (1, 3, 10 years, etc…), your tolerance for risk, and the type of income you earn (variable or consistent).
