Your asset allocation is the basic structure of your investment portfolio defining the target percentage you want to hold in different categories of assets. Start creating your asset allocation by deciding how much you want to invest in the two major categories, stock mutual funds and interest earning assets. Next break your allocation down into more specific categories including cash, CDs, bonds, large cap stock, mid-cap stock, small cap stock, international stock, emerging markets stock and real estate. Setting an appropriate, well diversified asset allocation helps you balance risk and return within your portfolio. Your asset allocation may change over time as your financial circumstances change. However, avoid changing your allocation too frequently based on short term fluctuations in the market.
The appropriate allocation depends on several factors including your age and investment time horizon, your financial goals, other risk factors in your life, your experience with investing and your emotional risk tolerance. Regardless of your investment goals, you need to maintain an emergency fund of readily available funds equal to at least four months of expenses.
Your financial goals are a major determinant in setting your allocation. Identify your major financial goals and when money is needed to support these goals. Design an asset allocation to meet these goals. Money needed in the short term should be held in safer, interest earning investments. The stock market should only be used for long term needs – generally at least five to seven years out.
You may be able to assume more risk in your portfolio if the timetable for your goals is flexible. The timeframe for money to cover things like college education or your emergency fund may be firm but there may be some flexibility on when you take a major vacation, remodel your home or plan to retire. Money needed for retirement is generally spent over twenty or thirty years. You won’t need your entire nest egg on the first day.
Your allocation is also dependent on risks taken in other areas of your life. For example, if you work in a volatile career with unpredictable earnings, own a small business or own rental property, you may want to reduce the risk in your investment portfolio. On the other hand, if you have a secure job and anticipate a generous pension, you may be comfortable taking more risk.
Regardless of your situation you need to feel emotionally comfortable with your allocation. If you are constantly worried about market fluctuations you may need a more conservative allocation. Historically the stock market has trended upward, but there will be years with negative returns. Create an allocation that gives you adequate emotional security to ride out swings in the stock market and helps you avoid selling when the market is down. If you are new to investing, start out slowly and test the water to see how you will react in a volatile market.