The Dough Roller » Asset Allocation

Target Retirement Funds

Rob Berger — Fri, 23 May 2008 10:54:39 +0000

Many people are intimidated by the idea of picking mutual funds. They wonder how they’ll know if they have made the “right” decision. I know that’s how I felt almost 20 years ago when I invested in my first fund. Fortunately, today there is an easy way to invest. It’s called funds of funds. These funds go by various names, such as target retirement funds or lifetime funds, but the concept behind them is all the same.

Funds of funds allow you to completely diversify your investments in a single mutual funds. Rather than investing in stocks and bonds, however, these funds of funds invest in other mutual funds. So when you invest in a target or lifetime fund, your money is then allocated into a number of mutual funds covering everything from large US companies to emerging markets to bond funds.

In this article we’ll first look at some Vanguard and Fidelity funds of funds for you to consider. Then will discuss the pros and cons of these investments. And finally, we’ll discuss some factors you should consider when deciding whether these lifetime funds are right for you.

Fidelity Freedom Funds and Vanguard Target Retirement Funds

Both Fidelity and Vanguard offer one stop mutual funds. Fidelity calls their funds of funds “Freedom Funds,” while Vanguard markets its product under the name, “Target Retirement Funds.” They both accomplish the same goal–diversifying your money into multiple mutual funds.

Fidelity offers a helpful tool to assist you in picking the Freedom Fund that’s right for you. You simply select how many years you have until retirement, and Fidelity recommends which Freedom Fund it believes is right for you.

Here I should noted that Fidelity has multiple Freedom Funds and Vanguard has multiple Target Retirement funds. They are both tied to how many years you have left until retirement. As you get closer to retirement, the mix of mutual funds they invest in becomes more and more conservative. This basically means that the amount of your investment in bonds increases over time.

So back to Fidelity’s Freedom Funds. For me, Fidelity recommends Freedom Fund 2030, which has the following mix of funds:

So how does the Fidelity Freedom Fund 2030 achieve this diversity? It takes every dollar invested in the fund, and places it into about 20 different Fidelity mutual funds. You can check out all of the funds it invests in here. So in other words, it does the work of diversifying your investments for you. One fund and you’re done.

Vanguard takes a somewhat more simplified approach, but either way you’re still just investing in one fund. Vanguard’s Target Retirement 2030 fund invests in just five mutual funds–four stock funds and one bond fund. And by following the link to Vanguard, you can use its nifty tool to see how your investments in one of its target funds will change as you near retirement.

The Pros and Cons of Target Date Funds

Let’s start with the advantages of target date funds. First, it’s an easy way to invest in mutual funds. Simply pick the fund based on how long you have until retirement, and then go spend time doing what you love to do. You can instant diversification, and the cost of the funds is reasonable. The Vanguard Target Retriement 2030 fund, for example, has an expense ratio of just 0.21%. In addition, your investments are automatically rebalanced and adjusted as you near retirement.

What you gain in simplicity, however, you do lose with lack of flexibility. First, these target date funds invest only in their own mutual funds. Fidelity’s funds of funds won’t be investing in Vanguard funds, for example. Second, other than picking which target fund to invest in, you don’t have a say in how Fidelity or Vanguard invests your money. Fortunately, there are ways to address these disadvantages, so read on.

How to Decide What’s Best for You

As you decide whether to invest in a target date fund, and if so, which one, keep these tips in mind:

Ignore your age: Just because you may have 25 years until retirement doesn’t mean you have to invest in the matching target date fund. You’re free to invest in the fund that has 30 years left until retirement (more aggressive) or 20 years (less aggressive) or any other target date fund. Remember that Fidelity and Vanguard design these funds with the mix of asset classes they think is best given a specific time horizon for your investments, but you’re free to pick whatever fund you want.
Add some other funds: You can take a hybrid approach by investing in a target date fund plus a few other funds. For example, you might invest 85% in a target date fund, 7.5% in an emerging market fund, and 7.5% in a REIT fund. You’ll give up some of the simplicity of investing in a single fund of funds, but you’ll add a bit of diversity.
Design your own portfolio: In the end, if the target date funds are not for you, it’s easy to design your own portfolio of investments. The starting place is my series called the Beginner’s Guide to Asset Allocation.

Asset Allocation for Near and Active Retirees

Rob Berger — Fri, 31 Aug 2007 09:00:44 +0000

As you near retirement, your allocation should reflect your shorter investing horizon. In retirement you’ll begin to spend some of the income from your investments, and financial advisers generally recommend changes to your asset allocation to reflect this short term need for cash. As a result, the allocation to bonds typically increases while your allocation to stocks declines. As we’ve discussed in earlier articles in this series, there is no one-size-fits-all portfolio. We have been looking at Richard Ferri’s recommendations in his book, All About Asset Allocation, which offers some good guidance.

In his book, Ferri suggests holding anywhere from 60% in stocks (aggressive) to 35% (conservative). The moderate portfolio, according to Ferri, would hold 50% in stocks. For Ferri’s two recommended portfolios, he takes the moderate approach. The first of these two portfolios is his basic portfolio, which uses six mutual funds and ETFs. Here it is:

[TABLE=9]

if you want a little more control over your asset allocation, Ferri also recommends a multiple asset portfolio. It includes 14 mutual funds and ETFs, and will require more time to manage. Here it is:

[TABLE=10]

Now, if you are really paying attention, you’ll notice a problem with the multiple asset allocation. Give up? When you add up the allocations, it only gets you to 95%! Well, nobody’s perfect, and I’m pretty sure Ferri would add the other 5% into the Fixed Income category, and my guess would be to put it in the Investment-grade fund. Otherwise, sit back, relax, and enjoy retirement.

Asset Allocation for Mid-Lifers (40s & 50s)

Rob Berger — Thu, 30 Aug 2007 09:00:47 +0000

Probably the happiest period in life most frequently is in middle age, when the eager passions of youth are cooled, and the infirmities of age not yet begun; as we see that the shadows, which are at morning and evening so large, almost entirely disappear at midday–Thomas Arnold 1795-1842, British Educator, Scholar

As you move into your 40s and 50s, your asset allocation should reflect your shorter investing horizon. While there is no one right asset allocation between stocks and bonds at this age, many recommend allocating between 70% (aggressive) and 40% (conservative) to stocks. Some may begin their 40s at the aggressive end of this allocation, and slowly move to the conservative allocation as they near 60. Richard Ferri, in his book All About Asset Allocation, proposes two portfolios (one basic, one multiple assets) that allocates 55% to stocks. Here are his two suggested portfolios:

[TABLE=8]

[TABLE=7]

I’m in my early 40s, and for me, these suggested portfolios are a tad too conservative. My current stock allocation is 85%, but through 401(k) contributions, I’m slowly increasing my bond investments. Even at 40 (and to some of you, that may sound ancient), I have 25 years until retirement and (hopefully) 20 or more years after retirement. So my investing horizon is still quite long. That said, I do find that as my investments grow, my tolerance for risk diminishes. All of which is to say, you have to decide what asset allocation is best for you. Ferri’s two suggested portfolios above, however, are a good place to start.

Asset Allocation for Generation X (20s & 30s)

Rob Berger — Wed, 29 Aug 2007 09:00:36 +0000

“A comfortable old age is the reward of a well-spent youth. Instead of its bringing sad and melancholy prospects of decay, it would give us hopes of eternal youth in a better world.”–American Abolitionist, Lydia M. Child.

And so it is with investing, too. In your 20s and 30s, you have a significantly long investing horizon that enables you to take more risk. For this reason, all investment books and articles I’ve ever read recommend an asset allocation weighted toward stocks. Bonds simply won’t produce the long-term returns most need to achieve a comfortable retirement. So let’s take a look at two actual portfolios, both recommended by Richard A. Ferri, CFA, in his book All About Asset Allocation.

How Much Stock Versus Bonds?

This is the first question to ask when building any portfolio. To help answer that question for yourself, look back at the chart in the stock and bond article in this series. It will show you what you may lose in a single year depending on your stock and bond mix. Ferri describes three stock/bond mixes: 85% stocks/15% bonds (aggressive), 70% stocks/30% bonds (moderate), and 55% stocks/45% bonds (conservative). Of these three, Ferri recommends the moderate allocation. I use the aggressive allocation. There is no one-size-fits-all, and what stock/bond mix an investor should use at this age will vary based on many factors, including risk tolerance and financial goals.

The Basic Portfolio

Now let’s look at some actual portfolios. Ferri’s basic portfolio for young investors uses just four mutual funds:

[TABLE=5]

In my view, this is a good, basic portfolio with low expenses that covers all of the major asset classes. I should add that I own shares in the real estate fund (VGSIX). If you don’t have access to Vanguard funds in your 401(k), most any major mutual fund company would offer similar funds.

Multiple Asset Class Portfolio

Ferri also recommends a more detailed portfolio that includes 12 mutual funds. Before I list those for you, it raises the question is 12 better than 4? Like anything, there are advantages and disadvantages to both. Managing four mutual funds is a lot less work than managing 12. On the other hand, the multiple asset class portfolio gives you exposure to asset classes (e.g., emerging markets) that a basic portfolio will not. The point is, it’s really up to you. So here is his multiple asset class portfolio:

[TABLE=6]

There are a couple of things to point out here. First, the investments with three-letter symbols are ETFs, which trade like stocks. You can substitute mutual funds for these investments if you prefer. Second, the DFA Emerging Markets fund can only be purchased through a financial advisor, which will cost you up to 1% or more. You can find other, less expensive investments. Third, the Vanguard Explorer fund is now closed to new investors, but alternatives are available. And finally, I should note that I own shares of VINEX, BRSIX, VGSIX and VIPSX.

Finally, as will all investment choices, you have to decide what is best for you. Take what Mr. Ferri has to offer, consider it along with any other information you have, and then make your own choices.

Asset Allocation in Action–Emerging Markets

Rob Berger — Mon, 27 Aug 2007 09:00:03 +0000

Emerging markets are less developed countries that are improving their free-market economy and standard of living. Emerging markets include such countries as Brazil, Russia, India and China. The question is whether an emerging market mutual fund should be a part of a diversified portfolio. to answer that question, several things should be considered, including the following:

Risk Tolerance: Emerging markets are not for the faint of heart. Returns will vary significantly from year to year, and substantial losses in the short term are not uncommon. From 1998 to 2004, for example, the MSCI Emeging Markets Index returns ranged from a high of 66% in 1999 to a low of -30% in 2000. So before investing in emerging markets, you need to candidly assess your risk tolerance. Fortunately, with a properly diversified portfolio, you can add riskier investments in the right amounts and increase your overall return while actually decreasing (or at least not increasing) the overall riskiness of the portfolio.

Holding Period: Risk cannot meaningfully be evaluated without also considering the holding period. The history of the stock market tells us that the risk of equity investments, as measured by volatility, goes down the longer the investment is held. In other words, a stock investment is more likely to go down in value over a one year period than it is over a ten or 20 year period. The bottom line–if you will need to liquidate your investments soon, think twice about investing in emerging markets.

Currency Risk: As with any investment in assets held in foreign currency, understand that the relative value of your currency to the foreign currency will impact your returns. An example best explains currency risk. If we assume that $1 can buy 1 Euro, than a European stock trading for 10 Euros will cost me $10. If in a year, the price of the stock has not budged, but it now costs $2 to buy 1 Euro, my investment has doubled as measured in U.S. dollars. That is, I can sell the stock for 10 Euros, and then sell the 10 Euros for $20. Of course, if over the course of the year I can buy 1 Euro for just $0.50, my investment would be cut in half, as measured in U.S. dollars. I know, clear as mud. The point is, foreign investments entail risks that domestic investments do not. If you are like many who believe the long term prospects of the dollar are not great and that it will go down in value as compared to many foreign currencies, than foreign investments become all the more attractive.

Your View of the Future: Many believe that the best growth opportunities are outside the U.S. In recent years we certainly have seen substantial growth in countries such as India and China. Will it continue and at what rate? I tend to believe that we will see significant growth outside the U.S., although the growth rate will be very inconsistent due to a variety of reasons including political instability, terrorism and natural disasters. I’ll let you know in about 30 years if I was right.

So Now What?

If you do want to add emerging markets to your portfolio, the question is how much and which funds. I personally keep about 10% of my portfolio in emerging markets through Vanguard’s Emerging Markets Stock Index Fund (VEIEX). It has a low expense ratio of just .42% and has done reasonably well for me. I’ve owned the fund for a number of years, and if I were buying more emerging markets today, I’m not sure I’d pick this one. It has done well over the last few years, but just about all emerging market funds have performed well. This is one area where I believe an actively managed fund just may have an advantage over an index fund.

I’ve recently been reading Richard Ferri’s book, All About Asset Allocation. For young investors with many years left to retirement, he recommends 5% emerging markets and specifically lists DFA Emerging Markets (DFEMX) fund. The problem with DFA funds is that they must be purchased through fee-only advisors, and for this reason, I’ve stayed away from them. It’s unfortunate, too, because DFA offers some very unique indexing options. Anyway, I mention it hear to give you another perspective. If you’d like to research some potential funds, you can use Morningstar’s mutual fund screener to quickly identify potential funds.

As always, what’s right for you will depend on many factors that only you can assess. As we continue this series, we will look in more depth at actually constructing a diversified portfolio of investments.

Asset Allocation in Action–Should a Diversified Portfolio Include a REIT Mutual Fund?

Rob Berger — Tue, 21 Aug 2007 09:00:44 +0000

We discussed REITs in the first part of this series. Now let�s look at why you should consider including them in your portfolio.

The main benefit of REITs, in my view, is diversity. REITs are one of the few asset classes that are not highly correlated to the S&P 500. That means that the performance of REITs doesn�t follow in lock-step the performance of the market. At the same time, REITs historically have performed very well. From 1989 to 2001, REITs returned 10.7% with a standard deviation of 16.1%, according to David Darst in his book, The Art of Asset Allocation : Asset Allocation Principles and Investment Strategies for any Market.

What this means is that REIT mutual funds during this period were highly volatile, with 95% of yearly returns ranging from -21.5% (the average minus two standard deviations) to 42.9% (the average plus two standard deviations). In a well diversified portfolio, however, REITs can improve returns with little added risk to the overall portfolio. I own two REIT funds:

Vanguard REIT Index (VGSIX)(6.2% of my portfolio)
Fidelity International REIT Index (FIREX)(2% of my portfolio)

So far in 2007, VGSIX has lost 13.6% and FIREX has lost 5.1%. From 2003 through 2006, however, VGSIX returned 35%, 30%, 12% and 35%. As I�ve repeated many times, with potentially greater returns comes potentially greater risk.

You will see that my allocation to REITs is about 8%, and my goal is 10%. You�ll read many books that recommend anywhere from 0% to about 20%. In William Bernstein’s book, The Intelligent Asset Allocator: How to Build Your Portfolio to Maximize Returns and Minimize Risk, he recommends 5% in one of his portfolios.

Should I own a REIT if I own real estate

This question comes up a lot. My answer is yes. I own four rental properties and my home, and I still put 10% of my portfolio in REITs. Why? Because REITs typically invest in office buildings, strip malls, apartment buildings and the like, not single family homes. Some REITs do invest in mortgages, so there can be some overlap with residential real estate, but for the most part, my REIT investments will behave differently than my rental properties. Others, however, believe that the investment in their home is sufficient exposure to real estate, and so avoid REIT mutual funds. You’ll obviously have to make your own decision on whether to own a REIT mutual fund.

One final thought. You probably own REITs even if you don�t own a REIT fund. Most REITs fall into the mid-cap category, so if you own funds in that category, those funds likely include some REITs.

Asset Allocation in Action–Value vs. Growth Mutual Funds

Rob Berger — Thu, 16 Aug 2007 09:00:13 +0000

I like good values. Whether I’m buying a car, an investment property or a stock mutual fund, the last thing I want to do is overpay. For this reason, my portfolio is value overweighted. By the way, if the term overweighted is new to you, all it means is that the percentage of my portfolio categorized as value is greater than the percentage of the entire market that is categorized as value. To show you what I mean, here are two Morningstar Style Boxes. The one on the left represents my portfolio, the one on the right represents an S&P 500 index fund:

The numbers in the style box of my portfolio represent the percentage of my investments that fall within each asset class. You’ll see that as compared to the S&P 500, my portfolio leans toward value and smaller companies. We already discussed why I favor smaller companies. So why do I favor value companies? Returns, of course.

From 1927 to 1998, large value stocks have returned an average of 13.99%, while large growth stocks have returned 10.04%. The difference is even more stark with small cap companies, where small value returned 17.47% and small growth just 2.18%. These numbers come from an excellent book on asset allocation, The Intelligent Asset Allocator: How to Build Your Portfolio to Maximize Returns and Minimize Risk.

So how do I overweight my portfolio toward value? Well, I invest in funds that buy value stocks. Here are the value oriented funds that I own, along with the percentage of my portfolio represented by each:

Allianz NFJ Small Cap Value (PSVIX): 9.77%
Dodge & Cox International (DODFX): 2.45%
Dodge & Cox Stock (DODGX): 9.57%

With respect to Dodge & Cox Stock, Morningstar now categorizes it as a blend between value and growth. Historically, it has been a value fund, but because many of the stocks it owns have done so well, it’s moved into the blend category. This is important to note, because mutual funds will change categories over time.

As always, I’m not recommending these funds or even my decision to seek out value funds–you have to make those decisions for yourself. But if I had to sum up my reasons for buying value funds, it would be this (which comes from Bernstein’s Intelligent Asset Allocator book): “Good companies are generally bad stocks, and bad companies are generally good stocks.”

I will say that many professionals recommend the value approach. In the Intelligent Asset Allocator, for example, Bernstein recommends a portfolio with 20% invested in value funds. Finally, if you stick with index funds, you should know that value based index funds are available. Vanguard has several, as does fidelity, and many other fund families.

Asset Allocation in Action–Small Cap vs. Large Cap Mutual Funds

Rob Berger — Tue, 14 Aug 2007 09:00:43 +0000

As we saw in Day 2 of this series, small cap stocks historically have enjoyed higher returns than large cap stocks. From 1926 to 1998, small caps have averaged a 12.18% return, while large caps have returned about 11.22%. Of course, small caps are more risky. The standard deviation for Vanguards S&P 500 Index is 7.35% according to Morningstar, while Vanguards Small Cap Index fund has a standard deviation of 12.21%. As a refresher, standard deviation tells us that about two-thirds of an investment’s yearly returns will fall somewhere between its average return – its standard deviation on the one hand, and its average return + its standard deviation on the other. Using the numbers above, two-thirds of the S&P 500′s returns will fall between 3.87% (11.22 – 7.35) and 18.57% (11.22 + 7.35). In contrast, two-thirds of the Small Cap index fund’s returns will fall somewhere between -.03% (12.18 – 12.21) and 24.39% (12.18 + 12.21). Thus, the higher the standard deviation, the more volatility you can expect in the investment.

So what�s this mean for asset allocation? My approach has been to invest about 20% of my portfolio in small caps (including both domestic and international). The idea here is to benefit from what I hope will be higher returns from small caps, while not going overboard and greatly increasing the risk of my overall portfolio. I split my small caps into three funds:

Bridgeway Ultra-Small Company Market (BRSIX): This fund invests in ultra small cap stocks, and its current holdings have an average market cap of $362 million.

Allianz NFJ Small Cap Value Instl (PSVIX): This fund invests in small cap stocks, and its current holdings have an average market cap of $2.11 billion. This fund is really on the borderline between small cap and mid cap.

Vanguard Explorer Fund (VINEX): This fund invests in international small cap and mid cap stocks, and its average market cap is currently $1.863 billion.

The point here is not to recommend these funds or my asset allocation. Rather, the point is simply to show you the choices I�ve made, which may or may not be appropriate for you. You should note from the above information, however, that not all small caps are created equal. You�ll see in the above funds that within the small cap category there is great variance in the size of the companies these small cap funds actually own. The Allianz fund market cap is several times larger than the average market cap for the Bridgeway fund. The point is that you need to look at the average market cap of the fund, rather than relying on the name of the fund, as the name can be deceiving. The risk, as measured by their standard deviation also can vary significantly from fund to fund. The standard deviation for the Bridgeway fund is 13.52%, while the other two funds have standard deviations of about 10.50%. This is to be expected given that Bridgeway invests in significantly smaller companies.

How does my allocation stack up against the pros?

You�ll see a lot of recommended asset allocations in books and published articles. Generally, for those with at least 10 or 20 years to go before retirement, the suggested allocations that I’ve seen range anywhere from about 10 to 25%. For example, Bernstein in The Intelligent Asset Allocator: How to Build Your Portfolio to Maximize Returns and Minimize Risk suggests 15% for a long-term portfolio. The Bogleheads in The Bogleheads’ Guide to Investing recommend 25% allocated to mid cap and small cap for a young investor, and about 15% for us middle-aged folks.

One critical thing to keep in mind is that if you own a small cap fund, be prepared to lose some money in the short term. As we’ve seen from the standard deviation, these funds are more volatile than large cap and bond funds. So if you can�t stand the heat. . . .

Asset Allocation in Action–Domestic vs. International Mutual Funds

Rob Berger — Thu, 09 Aug 2007 11:49:04 +0000

This has been a hot topic as of late. How much should one invest in international or foreign stocks? Let me first say that the question, as phrased, is a touch on the arrogant side. We Americans just assume that everybody knows that by domestic we mean U.S. stocks. I guess everybody does understand that, but U.S. versus non-U.S. may be a clearer way to state the question.

As a starting point, about 50% of the global market capitalization is in U.S. companies. The significance of this fact, to me, is that about 50% of the global market capitalization is NOT in U.S. companies. If one is looking to mirror the market, 50% of the stock portion of a portfolio should be invested in foreign funds. Given that about 50% of the world’s market cap is outside the U.S., it’s interesting to note that many financial advisers suggest a portfolio comprised of significantly less than 50% in foreign funds. In his book The Intelligent Asset Allocator: How to Build Your Portfolio to Maximize Returns and Minimize Risk, Bernstein recommends portfolios with as little as 15% in foreign funds. The Bogleheads in The Bogleheads’ Guide to Investingrecommend portfolios with just 10% allocated to international funds.

Why is this? Risk. Non-U.S. investments are often viewed as carrying more risk than U.S. investments. Using standard deviation as a measure of risk, it does appear that international funds are riskier than U.S. funds. Using two well known indexes as examples, the Vanguard Total Stock Market Index (VTSMX) has a standard deviation of 7.94% according to Morningstar, while Vanguard’s Total International Stock Index fund (VGTSX) sports a standard deviation of 9.73%.

Ok, so how much should one invest in international funds? Like any aspect of asset allocation, there is no one right answer. Many recommend allocations of no more than 35%, and as noted above, many recommend much less. Because international funds tend to carry more risk, many suggest reducing your exposure as you near retirement.

My Approach

I allocate about 35% to international funds, which includes not only stock funds but also a portion of my REIT funds and my bond funds. Here are the international funds I own, followed by the percentage of my total portfolio each represents:

Vanguard Emerging Markets Stock Index (VEIEX)(12.5%)
Vanguard International Explorer (VINEX)(11%)
Fidelity Diversified International (FDIVX)(8.5%)
Templeton Global Bond (TPINX)(1.8%)
Fidelity International Real Estate (FIREX)(1.8%)

Again, I’m not suggesting any of these funds or the allocation is right for you. We each need to make our own investing decisions. But these are the choices I’ve made.

One final thought. It’s my view that the U.S. dominance in financial markets will gradually wane. This isn’t a brilliant thought on my part, many have the same view. Just read Friedman’s The World Is Flat [Updated and Expanded]: A Brief History of the Twenty-first Century to get an idea of how globalization is changing everything. The point is that I believe international investments will provide an excellent opportunity for growth over the next few decades that U.S. investments will not. Am I right? I’ll let you know in 20 or 30 years.

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How Much to Invest in Stocks and Bonds

Rob Berger — Wed, 08 Aug 2007 10:47:14 +0000

The allocation of your investments between stock and bond mutual funds is one of the most important asset allocation decisions you’ll make. Fortunately, there are some really easy to apply rules of thumb to help us make a reasonable decision. Before we get to how much to invest in stocks vs bonds, however, here are several things to keep in mind:

Your Allocation Will Change Over Time: The allocation between stocks and bonds typically changes as your investing horizon draws closer. Somebody with 40 years to go before retirement will likely want far more invested in stocks than somebody who will retire in 5 years. When I began investing in my mid-20s, I didn’t own any bond funds. I didn’t buy my first bond fund until my late thirties, and at 40, my allocation is 80/20 in favor of stock mutual funds. The point isn’t that my choices are best, but rather that the allocation between stock and bond funds will change over time.
There is No One Right Answer: Although the rules of thumb discussed below are helpful, there is no one right allocation between stocks and bonds. As I discussed in the article yesterday about why asset allocation is important, understanding your tolerance for risk and desired returns will influence your allocation between stocks and bonds, and these decisions vary from one individual to another.
Your Tolerance For Risk Changes Over Time: In your 20s when you first start investing, you may not be concerned with a 30% drop in the market. In your 40s with 3 kids and a 5 or 6 figure portfolio, a 30% drop in the market will take on a whole new meaning (trust me).
Investing is a Learning Process: I’ve learned a lot in the 15 years I’ve invested, and my opinions about asset allocation and a lot of other financial issues have changed over that time. The point is not to approach these decisions rigidly, recognizing that your views will change.

Rules of Thumb

Enough with the philosophical happy talk, what’s the proper allocation? Well, good question. As a starting point, many view a neutral allocation between stocks and bonds to be 60% stocks and 40% bonds. If you read a lot of the literature on asset allocation, you’ll see the 60/40 split used frequently. According to one report published on FundAdvice.com, a 60/40 allocation produced a compound annual return of 10.4% from 1970 to 2006. Now that doesn’t mean that a 60/40 split is right for everybody, which brings us to an oft-repeated formula for determining a reasonable allocation: 120 – your age = the percentage to invest in stocks, with the remainder allocated to bonds.

At 40, according to this formula, I should invest 80% in stocks (120-40=80) and the remainder, or 20%, in bonds. As it turns out, the 80/20 split is what I use. Whether the formula is right for you, only you can decide. A more conservative approach is to allocate a percentage to bonds that equals your age. In my case, that would result in a 60/40 split (boy do I feel old right now). In deciding what’s best for you, you may want to consider the following data taken from The Intelligent Asset Allocator: How to Build Your Portfolio to Maximize Returns and Minimize Risk, written by William Bernstein:

[TABLE=4]

Of course, in answering how much you can tolerate to lose, you must be brutally honest with yourself. If your like me, you won’t really know how much you can tolerate losing until you experience it. That said, Bernstein’s chart is certainly a good place to start in determining your proper allocation between stocks and bonds.

Tomorrow we’ll look at allocating your investments between domestic and international funds.

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