Here's How to Determine Your Ideal Asset Allocation Strategy

By Matthew Frankel Markets Fool.com

Asset allocation is one of the most important concepts for all investors to know. How much of your investment portfolio should be in stocks, bonds, and cash? The correct answer for you depends on your age and your investment goals.

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The three main types of assets

While there are literally tens of thousands of possible investments to make in your brokerage account, they can all be separated into one of three categories.

1. Equities (stocks):Equities represent shares of ownership in businesses, and they're typically the most volatile of the three types of assets, although there is a large range of riskiness within this category. As a group, equities have historically outperformed other asset classes over long periods of time, which is why they are good investments for money you won't need anytime soon.

Image source: Getty Images.

Within the category of equities, there are a few sub-categories you should be aware of. For example, an equity fund offered by your 401(k) may be described as "mid-cap value." So here's a quick guide to understanding terms like this.

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  • Value stocks -- Companies perceived to trade at a discount to their peers. They're generally considered well-established businesses with strong fundamentals.
  • Growth stocks -- Companies that are growing faster than average and therefore offer the potential for greater returns than value stocks, as well as greater risk of losses.
  • Large-cap stocks -- Generally speaking, companies whose market capitalization is $5 billion or greater, though some definitions set the threshold higher or lower.
  • Mid-cap stocks-- Companies with market caps of $1 billion to $5 billion.
  • Small-cap stocks-- Companies with market caps of less than $1 billion.
  • International stock funds -- Funds that invest in companies based outside the U.S.
  • Global stock funds -- Funds that invest in companies all over the world, including the U.S.
  • Emerging-market funds -- Funds that invest in stocks based in rapidly growing, young economies. Countries like China, Brazil, and India are examples of emerging markets, as opposed to developed economies like the U.S., the U.K., and France.

2. Fixed income (bonds):Fixed-income assets make regular interest payments based on an agreed-upon interest rate. These payments may stay the same (fixed-rate) or may change over time (variable-rate), depending on the type of asset. For example, inflation-protected bonds make higher payments when inflation occurs. Generally speaking, fixed-income assets are less volatile than stocks, though they're not risk-free.

As with equities, there are several different types of fixed-income investments:

  • Government bonds -- Bonds issued by the Federal government, such as Treasury bonds.
  • Municipal bonds -- Bonds issued by local governments.
  • Corporate bonds -- Bonds issued by corporations to fund their operations. Depending on the company's credit rating, these can be extremely stable, extremely risky, or anywhere in between. High-quality bonds are known as investment-grade.
  • Short-term bonds -- Bonds that mature within five years. All other things being equal, longer maturities typically translate to higher interest rates, but more volatility.
  • Intermediate-term bonds -- Bonds that mature in five to 10 years.
  • Long-term bonds -- Bonds that mature in 10 years or more.

3. Cash:This category refers to physical cash, as well as interest-bearing vehicles such as savings and money market accounts. Even if cash investments bear interest, their returns generally don't even keep up with the rate of inflation, making them poor long-term investment vehicles. Cash investments are typically only appropriate for money that is needed soon, or money that you absolutely cannot afford to lose. I usually only recommend cash investments for people who are in or near retirement -- and even then, only as a small percentage of their portfolios.

A general rule of thumb for asset allocation

While it's admittedly not perfect, a quick rule of thumb is to take your age and subtract it from the number 110 in order to find out how much of your money should be in equities. For most people, the remainder should be in fixed-income, with some cash for those at or near retirement.

For example, if you're 40 years old, this implies that 70% of your portfolio should be invested in equities, with the other 30% in fixed income. Note that this rule assumes you do not already have the money you need to achieve all your financial goals, including funding a comfortable retirement.

Try this risk tolerance quiz

While the "rule of 110" is a good starting point, it doesn't take into account your particular situation. In other words, not every person who is 40 years old has the same risk tolerance. Some 40-year-olds are preparing to pay for their child's college education, while others have no children and very different short-term financial concerns. The 110 rule is also not fitfor someone who is only looking to preserve the wealth they have, rather than grow it indefinitely.

With that in mind, here's a 10-question quiz you can take that considers not only your age, but your specific situation and your own attitude toward risk.

Note that this calculator is for estimation purposes only and should not be considered financial planning or advice. Like any tool, it is only as accurate as the assumptions it makes and the data it has, and it should not be relied on as a substitute for a financial advisor or a tax professional.

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