How to Pick the Best Asset Allocation for You

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We've all heard the adage that you shouldn't put all your eggs in one basket. Well, allocating your money to a variety of assets applies this advice to investing. There are many issues to consider when deciding how many and what type of baskets you should stash these figurative eggs in. Here's what you need to know to pick the asset allocation strategy that works best for you.

Asset allocation is the process of dividing your portfolio among different asset classes. Different asset classes include stocks, bonds, real estate, and cash assets.

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Each asset classes performs differently over time because of economic conditions, market forces, and government policies. While investing in stocks gives you the greatest potential for gains, some years overall stock returns are the lowest among different asset classes. When you diversify your investments across different asset classes, you reduce your risk. This is because when one asset class performs poorly, it can be offset by better performance of the other asset classes.

Diversification also reduces the volatility of your portfolio, protecting you from huge swings in the value of your investments. When your portfolio combines stocks (which are relatively volatile) with bonds (which are very low-volatility), you reduce the risk that your portfolio will take sudden and massive losses. On top of that, the right asset allocation can also give you better returns.

Identify your objectives and time horizon

Your first step in creating an effective asset allocation strategy is identifying your goals and considering how much time you have to reach these objectives. Do you want to retire at 50? Start a business? Travel the world in retirement? Identifying your goals helps you determine how much money you'll need and how much risk you may need to take on to reach your objective.

The longer your time horizon, the more risk you can afford to take, as you have time to ride out any market downturns. Almost all of your portfolio should be invested in stocks if you have time on your side. However, once you're near your goal -- for example, when you're less than a decade from retirement -- you may want to shift more of your money into lower-risk assets like bonds. This will help to protect your savings from taking a major hit right before you need them most.

While stocks have achieved impressive returns over long periods of time, no one knows when the next market correction will occur. This is why it's important to use asset allocation to reduce your risk. Money that you will need within five years should not be invested in stocks. If the market crashes and the value of your investments drops, you don't want to have to sell at a loss because you need the money. Hold money you will need to use soon in safer asset classes.

Assess your risk tolerance

Even if you have the same time horizon as another person, the ideal asset allocation for your investments may look vastly different from someone else's ideal portfolio. The level of risk you accept must pass the "I can sleep at night" test.

To figure out your risk tolerance, imagine a few investment scenarios and imagine how you'd react. Let's say you have a $10,000 portfolio, and 80% is allocated to stocks. How would you feel if the market crashed and the value of your equity position dropped by 50%? Suddenly, your $10,000 portfolio would a value of $6,000. If you think you might panic and sell in order to avoid further losses, then you should keep a lower percentage of your investments in equities. On the other hand, if your instinct would be to buy more shares while prices are lower, then you have a higher tolerance for risk, and you can safely invest more of your portfolio in equities.

Even if you realize you are risk-averse and prefer a conservative investment strategy, it's important to invest a substantial portion of your long-term savings in equities. Without a stock position, your portfolio is unlikely to keep pace with inflation, let alone beat it.

Identify your target portfolio

After determining your risk tolerance, decide on your ideal allocation. One strategy is using an age-based calculation to determine how to allocate your retirement savings: Subtract your current age from 110 and hold that percentage in equity investments. For example, if you're 45 years old, you may consider holding 65% (that's 110 minus 45) of your portfolio in equities. If you're a more conservative investor, you could subtract your age from 100 instead of 110. If you want to invest more aggressively, make it 120.

All that said, while riskier assets like stocks provide opportunities for higher returns, the best- and worst-performing asset classes vary from year to year. Using asset allocation helps you minimize your losses in a year when a particular asset class performs poorly.

Select your investments

You can reduce your risk by investing across different asset classes, but be sure to diversify your holdings within each asset category as well. In other words, hold a variety of equity assets, not just one stock, and choose equities from large, small, and mid size companies with different objectives (growth or value) in different industry sectors. Consider foreign stocks in both developed and emerging markets as well. You can select your assets individually or choose a mutual fund where the fund manager has done the diversifying for you.

You can diversify your bond holdings by choosing domestic or international bonds or choosing government or corporate bonds. While there's little risk in cash assets, they can be distributed among money market funds, certificates of deposit, or Treasury bills.

Review and rebalance

If your portfolio is performing as it should, over time, your target allocation will get out of balance. This makes sense, as you would expect your equity holdings to outperform your bond assets, so over time, you will end up with larger growth from your equity holdings.

For example, let's say you invest $10,000 to create a portfolio with your ideal asset allocation of 80% stocks and 20% bonds. Your original portfolio will have $8,000 in stocks and $2,000 in bonds. After five years, imagine your stock holdings have grown to $12,000 and your bonds are worth $2,400.

The asset allocation after these gains is now 83% stocks and 17% bonds. To get the portfolio back to the target allocation, you would need to sell some of the equities and allocate the proceeds toward bonds. You can make these adjustments at fixed intervals or when your assets are out of balance by a certain percentage.

You should also consider adjusting your target portfolio to a more conservative allocation as you age. When the stock market crashed in 2008, a lot of near-retirees were wishing they had adjusted their allocation sooner.

Finding an asset allocation strategy that works for you takes some introspection and planning. Be sure to diversify your holdings not only across asset classes, but within them as well. Check your baskets regularly and move your eggs as needed.

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