When creating your investment portfolio, one of the first things that you have to ask yourself is this: How much of my money should be invested in stocks and bonds? How can you determine the right asset allocation for your investment portfolio?
There is really no right or wrong answer to this question. Your asset allocations between these two asset classes would depend on a number of factors, including your risk tolerance, investor experience, age, and investment philosophy.
To help determine how much you should invest in stocks and bonds, here are some things to consider.
The right asset allocation for your age
Before, the general rule of thumb was to subtract your age from 100 to know the stock percentage you need to have in your portfolio. For example, if you are 30 years old, you should hold 70 percent stocks. If you are 70, you should invest 30 percent of your portfolio in stocks.
Today, many financial planners are promoting that the rule should be 110 minus your age. It is due to the idea that if people want to preserve their money for a longer period, they will need the additional growth that stocks can offer.
As you age and become more dependent on savings and investments to finance your life, you are more likely to shift further towards less risky investments.
The general idea is that people become risk averse, as their ability to produce income weakens as they grow older. They also do not want to spend their older years working.
This means that a big portion your portfolio will be focused on bonds. You may receive fewer returns than stocks, but they usually become more preferable later in life, given their low-risks potential.
Read also 5 Reasons Why Invest while You’re Young to know the benefits of investing at a young age.
Your Risk Tolerance
How much risk you can tolerate hinges on whether a market loss would hold you back from meeting your financial needs. It also depends on your personal situation. For instance, if you have a stable job with a steady income, you might have higher tolerance for stock market risk.
Risk and rewards go hand in hand. If you are looking to achieve high returns, you need to deal with heavy risks. Then again, if you really want to steer clear of risks, you are likely to profit less.
There are a lot of ways to regulate risks. The most popular method by far is to tweak the balance of your portfolio between stocks and bonds.
The Type of Stocks and Bonds You Should Own
Stocks are not as predictable as bonds, in terms of returns or eventual value, but it has growth potential. Not only can they rise in value, but many can regularly increase their dividends year after year, providing you a bigger income flow.
So when it comes to investing in stocks, you have a lot of options. Here are some brief descriptions of the stocks you can include in your portfolio.
- These are stocks that trade at a discount relative to its fundamentals, such as dividends, profits, and sales. Value stocks are often regarded as undervalued. They are usually recognized for having a high dividend yield, low price-to-book ratio, and / or low price-to-earnings ratio.
- Growth stocks are companies that tend to expand at a much faster pace than the overall markets. They are more likely to grow in capital value than generate high returns. However, growth stocks overall represents higher risk than value stocks.
Large-cap (Big-cap) Stocks
- Companies with a market capitalization value of $10 billion or more are generally considered as large cap stocks. They are common among both growth and value investors as a part of an overall asset allocation.
- Some popular large-cap companies include Amazon.com Inc., Berkshire Hathaway Inc., Alibaba Group Holding Ltd., and Johnson & Johnson.
- As the name suggests, mid-cap stocks stand at the middle of the group between large-cap and small-cap stocks. Mid-cap stocks are shares of companies with a market cap between $1 billion and $5 billion, though some analysts deem firms with a $10 billion market cap to be mid-cap.
- Small-cap stocks are those businesses with a market cap between $250 million, or $300 million and $2 billion. They typically perform well early in an economic recovery and are often viewed as good investments because of their low valuations and ability to become big-cap stocks.
Know the latest penny stocks this year by reading the Top 10 Penny Stocks You Should Watch in 2018.
Note: If you intend to invest in individual stocks, pick at least 15 to 20 stocks across different industries, and a handful from each category above. Allocate a large part of your assets in larger, reputable companies, but bear in mind that diversification is still the most crucial point.
With bonds, income is predictable and you will have the guarantee of retrieving your principal. Still, as with any investments, bonds are not risk-free.
Bond-based Mutual Fund or ETF
- A bond fund or two that matches your risk tolerance could be all that you need. Several investors invest in bond-based mutual fund or exchanged traded fund (ETF), as this is enough to fulfill their needs.
- The goal of allocating a part of your portfolio to bonds is to control the volatility level of stocks and create a consistent flow of income. It is not exactly about establishing growth for the long-term or beating the market.
- However, price declines of these funds are not only based on the prices of the bonds they have. They also drop based on the supply and demand of the overall bond market, which is significantly uncontrollable.
- If you are looking for a “set it and forget it” tactic for funding retirement, a target-date fund, also known as the “lifestyle fund”, might just be what you need.
- Target-date funds invest in age-appropriate stocks and bonds. It gradually moves its allocation from stocks to bonds as the target date draws near, or as you grow older. The precise combination will depend on the fund company.
- This type of fund puts your retirement savings on autopilot. They choose the mutual funds, and you decide the date or year of your retirement.
4 Allocation Approaches
Using a strategic asset allocation approach, you create your investment mix based on historical records of returns and volatility levels of various asset classes.
Investment success can be seen through outcomes in numerous year time periods. Therefore, the allocation approaches below offer results for the long-term.
100 percent Stocks
You may allocate 100 percent of your portfolio to stocks if you intend to acquire more than 9 percent returns. The disadvantage of this strategy however, is that at some point, your portfolio could go through a single calendar quarter.
This means that if you invested $10,000 for instance, and the drop is as much as 30 percent, the value will be reduced to $7,000. The drawback might also be 60 percent or more for the whole calendar year. Still, the downbeat periods ought to be offset by the upbeat periods.
80 percent Stocks, 20 percent Bonds
If your aim is to achieve a return of over 8 percent in the long term, then you could invest 80 percent in stocks and 20 percent on bonds.
A 20 percent decline is then expected to occur for the quarter and maybe a 40 percent weakness for the entire period. Rebalancing should be performed annually when you are using this allocation.
60 percent Stocks, 40 percent Bonds
If your long-term rate of return target is 7 percent or more, allocate 60 percent of your portfolio to stocks and 40 percent to bonds.
You will then encounter a single calendar quarter as well as a full calendar year of having your portfolio slipped by as much as 20 percent in value. Annual rebalancing is also recommended for this type of allocation.
Below 50 percent Stocks
Invest fewer than 50 percent in stocks if you would rather secure capital than receive bigger returns. You will, however, still have volatility and a year, or quarter of seeing your portfolio decline by 10 percent.
Note: The stocks and bonds allocations stated above serve as a guide for those who are not yet retired. These may not suit those who have been retired or are preparing for retirement, where they have to regularly withdraw money from their savings and investments.
The bottom line is that your portfolio is better off having both stocks and bonds. As a general rule, try subtracting your age from 110 to find out your target stock allocation, with the remainder of your portfolio in bonds.
While bonds have some benefits over stocks, they do have their own set of risks. As with any investment, it is always ideal to do your research before you hand over any of your hard-earned money. Mulling over the risks against rewards in advance can save you from potential losses.
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