How to Allocate Your Investments Among Stocks, Bonds, and Cash
One of the most important decisions investors make is how to allocate their capital among stocks, bonds, and cash. (“Cash,” in this case, refers to investments with no risk of loss, such as bank accounts, certificates of deposits, money market funds, etc.).
The first step in determining what allocation is right for you is understanding the link between risk and long-term total returns, and then assessing your risk tolerance, topics covered in Getting Started in Bonds, Parts 1 and 2.
Once you have a sense of how much risk you can – and should – take in light of your specific objectives (retirement, saving for a down payment on a home, etc.), the next phase of the process is determining the appropriate allocation among the three categories. Keep in mind, what follows is a general guide for educational purposes. If you find this confusing or intimidating, contact a fee-only financial advisor.
Matching Your Asset Allocation With Your Goals
First, let’s start with the crux of the asset allocation decision: what percentage to invest in stocks and bonds. Stocks have more risk than bonds, meaning that their short-term fluctuations tend to be much higher. At the same time, however, their longer-term returns also tend to be higher than those of bonds. Bonds, in contrast, tend to be lower risk (i.e., less volatile) in the short-term, but their longer-term returns tend to be lower than those of stocks. Keep in mind, however, that certain types of bonds (such as high yield and emerging market bonds, can be nearly as risky as stocks.
Most investment literature recommends a static mix between stocks and bonds. A typical approach would be:
This type of allocation breakdown is largely accurate on the surface, but it fails to account for the fact that most people have different “buckets” of cash set aside for different purposes and time frames. At the very general level, money that’s needed in the short term should be invested conservatively, whereas money that isn’t needed for a longer period can be more aggressively (if you’re fully comfortable taking the risk).
Here’s an example. An old saw of investing is that your allocation to stocks and bonds should match your age. In other words, a 40-year old investor should have 40% in bonds and 60% in stocks. The problem with this approach is that the investor in question may have multiple needs over a period of time: a down payment on a house (one year), college savings (needed in 15 years), and retirement (25 years). In this case, the static 40-60 breakdown doesn’t work. Should the investor have 60% of his or her house down payment money, needed in just year, in stocks? Absolutely not – stocks can fluctuate wildly, and in a worst case scenario the investor could lose 40% - making the house purchase unachievable. This is money that needs to be kept as safe as possible.
Conversely, should he or she have 40% of cash that isn’t needed for another 25 years in bonds? Again, the answer is no – this is cash that the investor can afford to invest more aggressively to take advantage of the longer-term return potential inflation-beating characteristics) of stocks.
The answer, then, is to keep the total picture in mind, but also to be sure that each bucket of savings is invested appropriately. In the most basic sense, the rule of thumb is that the shorter your time horizon, the less risk you should take; the longer the time horizon, the more risk you can take providing that you’re comfortable doing so.
Learn more:
The Key Differences between Stocks and Bonds
Why Invest in Bonds?
The Role of Cash
Ultra-conservative, short-term investments have a bad reputation. In early June, 2013, a Google search for the phrase “Cash is trash” generated over 42 million results. This is a sign of the times, as yields on low-risk investments having paid next to nothing since the 2008 financial crisis. Worse, not only are yields low on an absolute basis, but for most ultra-safe investments the yields are far below the rate of inflation – meaning that investors are losing purchasing power with each passing day.
That’s the bad news. The good news is that there is always a role for such investments since everyone has some money that absolutely needs to be kept safe. Whether it’s an emergency fund or cash that is needed for a specific reason in the next one to two years (for example, a college tuition payment due in the next six months), “cash”-like investments are a necessary tool in asset allocation.
Having said this, investors should strive to hold only as much cash as is necessary to ensure the protection of the money they can’t afford to lose. After this point, holding too much cash results in returns below the rate of inflation as well as the “opportunity cost” of missing the boat on investments with the potential for higher longer-term returns.
The Bottom Line
Achieving the right mix of stocks, bonds, and cash is a key component to long-term investment success. Use the above as a guide, but keep in mind that each person has his or her own specific situation and risk tolerance. Also, an allocation plan evolves over time: what might be right today may not be right five or ten years from now. Learn more about how to address the issue of changing objectives in Getting Started in Bonds Part 4 – The Importance of Portfolio Rebalancing (coming in July).
Disclaimer: The information on this site is provided for discussion purposes only, and should not be construed as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities. Always consult an investment advisor and tax professional before you invest.
The first step in determining what allocation is right for you is understanding the link between risk and long-term total returns, and then assessing your risk tolerance, topics covered in Getting Started in Bonds, Parts 1 and 2.
Once you have a sense of how much risk you can – and should – take in light of your specific objectives (retirement, saving for a down payment on a home, etc.), the next phase of the process is determining the appropriate allocation among the three categories. Keep in mind, what follows is a general guide for educational purposes. If you find this confusing or intimidating, contact a fee-only financial advisor.
Matching Your Asset Allocation With Your Goals
First, let’s start with the crux of the asset allocation decision: what percentage to invest in stocks and bonds. Stocks have more risk than bonds, meaning that their short-term fluctuations tend to be much higher. At the same time, however, their longer-term returns also tend to be higher than those of bonds. Bonds, in contrast, tend to be lower risk (i.e., less volatile) in the short-term, but their longer-term returns tend to be lower than those of stocks. Keep in mind, however, that certain types of bonds (such as high yield and emerging market bonds, can be nearly as risky as stocks.
Most investment literature recommends a static mix between stocks and bonds. A typical approach would be:
- Very conservative: 90%-100% bonds, 0-10% stocks
- Conservative: 75% bonds, 25% stocks
- Moderate 40% bonds, 60% stocks
- Aggressive: 20% bonds, 80% stocks
- Very Aggressive: 0-10% bonds, 90%-100% stocks
This type of allocation breakdown is largely accurate on the surface, but it fails to account for the fact that most people have different “buckets” of cash set aside for different purposes and time frames. At the very general level, money that’s needed in the short term should be invested conservatively, whereas money that isn’t needed for a longer period can be more aggressively (if you’re fully comfortable taking the risk).
Here’s an example. An old saw of investing is that your allocation to stocks and bonds should match your age. In other words, a 40-year old investor should have 40% in bonds and 60% in stocks. The problem with this approach is that the investor in question may have multiple needs over a period of time: a down payment on a house (one year), college savings (needed in 15 years), and retirement (25 years). In this case, the static 40-60 breakdown doesn’t work. Should the investor have 60% of his or her house down payment money, needed in just year, in stocks? Absolutely not – stocks can fluctuate wildly, and in a worst case scenario the investor could lose 40% - making the house purchase unachievable. This is money that needs to be kept as safe as possible.
Conversely, should he or she have 40% of cash that isn’t needed for another 25 years in bonds? Again, the answer is no – this is cash that the investor can afford to invest more aggressively to take advantage of the longer-term return potential inflation-beating characteristics) of stocks.
The answer, then, is to keep the total picture in mind, but also to be sure that each bucket of savings is invested appropriately. In the most basic sense, the rule of thumb is that the shorter your time horizon, the less risk you should take; the longer the time horizon, the more risk you can take providing that you’re comfortable doing so.
Learn more:
The Key Differences between Stocks and Bonds
Why Invest in Bonds?
The Role of Cash
Ultra-conservative, short-term investments have a bad reputation. In early June, 2013, a Google search for the phrase “Cash is trash” generated over 42 million results. This is a sign of the times, as yields on low-risk investments having paid next to nothing since the 2008 financial crisis. Worse, not only are yields low on an absolute basis, but for most ultra-safe investments the yields are far below the rate of inflation – meaning that investors are losing purchasing power with each passing day.
That’s the bad news. The good news is that there is always a role for such investments since everyone has some money that absolutely needs to be kept safe. Whether it’s an emergency fund or cash that is needed for a specific reason in the next one to two years (for example, a college tuition payment due in the next six months), “cash”-like investments are a necessary tool in asset allocation.
Having said this, investors should strive to hold only as much cash as is necessary to ensure the protection of the money they can’t afford to lose. After this point, holding too much cash results in returns below the rate of inflation as well as the “opportunity cost” of missing the boat on investments with the potential for higher longer-term returns.
The Bottom Line
Achieving the right mix of stocks, bonds, and cash is a key component to long-term investment success. Use the above as a guide, but keep in mind that each person has his or her own specific situation and risk tolerance. Also, an allocation plan evolves over time: what might be right today may not be right five or ten years from now. Learn more about how to address the issue of changing objectives in Getting Started in Bonds Part 4 – The Importance of Portfolio Rebalancing (coming in July).
Disclaimer: The information on this site is provided for discussion purposes only, and should not be construed as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities. Always consult an investment advisor and tax professional before you invest.
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