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| The Basics | How to make asset allocation work for you
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Adding diversity to your portfolio, or asset allocation, helps you to control risk and meet your financial goals. Here are four scenarios for mixing the investments in your 401(k) as you plan your retirement.
By Jim Jubak
You may not realize it, but you probably already practice asset allocation. That's what you're doing if you buy bonds when interest rates seem high, or you sell stocks when the equity market feels risky, or you move assets into a money-market account in preparation for a down payment or a big tuition bill.
But while we may practice a rudimentary form of asset allocation, most of us don't get all we can from the approach. Asset allocation can help an investor to control risk, to match a portfolio with specific financial goals, to increase the predictability of returns and more.
The principles behind asset allocation are simple.- First, history shows that not all classes of assets move up and down at the same time. One year, stocks of large companies may generate the best returns, while in another it will be government bonds or even a bank certificate of deposit.
- History also tells us that some asset classes are far more volatile than others. They may go from big gains one year to big losses the next, while the performance of less-volatile counterparts remains within a much narrower range.
If an investor could predict which asset classes would do best in any specific time period, there would be no need for asset allocation. Such a psychic would move into stocks when they're about to rack up a 30% return, and move into cash when stocks are headed for a tumble. Investors with an endless amount of time before they need their money don't have much need for asset allocation either. Just put everything into the asset class with the highest average returns over the long haul and ride out the dips.
Who needs to allocate?
But asset allocation is ideal for those of us who aren't psychic, who need money in the foreseeable future and who are prone to do silly things if our net worth dips too fast. By balancing the types of assets we own among stocks, bonds, and cash, we trade the best returns we'd get if we timed the markets perfectly for predictability and piece of mind.
No one mix of assets is right for everyone all the time. Those closer to needing their money may put a premium on predictability. For them, an asset allocation that tries to minimize losses is a good choice. But that same allocation would be a poor choice for a young investor with 40 years to go before retirement. It sacrifices too much potential return for safety that this investor doesn't need.
We've built six scenarios that consider time to retirement, attitude toward risk and other investments and resources that are available. You can modify these guidelines to suit your own individual circumstances. None of these scenarios include cash, per se. We assume that you'll keep an emergency fund equal to two or three month's worth of income.
Sample asset allocations
Years to retirement: 20 or more
Profile: Conservative investor who believes good times for stocks wont last forever.
Recommended allocation:- 60% equities
- 40% 10-year (or longer maturity) Treasury bonds
Until the early 1990s, a conservative asset allocation would have recommended 60% equities and 40% bonds. That plan was based on data that showed the Standard & Poors 500 stock index outperforming long-term government bonds by about 5.4 percentage points a year in the period from 1926 to 1994. With that spread -- a total return of 10.2% a year for stocks vs. 4.8% a year for long-term government bonds -- 60% stock/40% bond portfolio offered a reasonable trade off of lower return for lower risk.
But in the last few years the spread has been exceptionally wide. For example, stocks beat long-term government bonds by 21 percentage points in 1996, 15.9 in 1997, and 13.4 in 1998.
Those numbers have led some financial experts to predict that returns for the two assets classes will revert to the historical pattern in the years ahead -- which would require substantial historical under-performance by stocks. An annual return of 8% is the most commonly mentioned figure. If this forecast were to come true, the traditional conservative asset allocation of 60/40 over the next decade would deliver more return with less risk than it has historically.
On the other hand, you may believe the near future will resemble the recent past, in which case you might prefer.
Years to retirement: 20 or more
Profile: Conservative investor who believes that recent outperformance by stocks will go on for a while.
Recommended allocation: - 80% equities
- 20% 10-year (or longer maturity) Treasury bonds for the next 10 years and then a shift toward a 70/30 mix.
Since 1995, an 80/20 mix has offered by far the best combination of risk and return of any asset allocation plan, thanks to the historically high returns delivered by stocks. That could continue for another decade. The U.S. economy may indeed have entered a period of higher-than-normal productivity gains, which would mean solid growth in corporate profits. Thanks to the pain of the 1980s, U.S. companies have become among the most efficient in the world, which would again translate into higher corporate profits. And a baby boom generation is just now entering its prime saving years. Since this generation prefers stocks to bonds, that could guarantee at least another 10 years of above-average returns from investing in equities.
That last factor also implies that bonds will outperform equities when the bulk of baby boomers starts to protect assets from volatility and then begins to withdraw more than it saves. At that point, this scenario suggests that bonds could narrow the historical performance gap with stocks.
Years to retirement: 20 or more
Profile: Your 401(k) is likely to be your total nest egg (besides Social Security).
Recommended allocation:This portfolio uses time to maximize your long-term return. It's meant to grow your 401(k) the fastest -- a necessity since this fund will provide the bulk of your savings for retirement. It's based on the fact that the average annual return for the mostly large-company stocks in the Standard & Poor's 500 over the last 10 years is about 16%.
You'll probably have to hold on through some pretty big dips; in a downturn, stocks can drop 20% or more in a few months. The good news is that you've got plenty of time to recover from periods like that, and the longer you hold stocks the less likely it is that you'll take a loss on your portfolio. For example, an investor holding stocks for any five-year period since 1926 lost money in seven of those periods. But hold on for 20 years and the worst result since 1926 is a 3.1% gain.
Years to retirement: 10
Profile: Your 401(k) is likely to be your total nest egg (besides Social Security.)
Recommended allocation:- 50% equities
- 50% 10-year Treasury bonds by the time you retire
As you get closer to retirement, it's time to start shifting your portfolio mix from one designed to maximize the size of your 401(k) to one that minimizes your exposure to the ups and downs of the financial markets. The last thing you want in retirement is to be forced to sell stocks during a market downturn to pay a bill or to take a trip.
So, each year for the next decade, you'll take 5% of your 401(k) funds out of stocks and move it into 10-year U.S. Treasury bonds. By the time you're set to retire, you'll have a portfolio divided about equally between stocks and 10-year bonds. Moreover, you'll have built a laddered bond portfolio that provides even more security. One tenth of your bonds will mature each year, and a bond that matures returns your full principal even if rising interest rates have knocked the market prices of newer bonds for a loop.
Years to retirement: 20 or more
Profile: Thanks to your company's profit-sharing program, your 401(k) won't be your total nest egg (besides Social Security).
Recommended allocation:- 70% equities (including your employer's stock)
- 30% 10-year Treasury bonds
Corporate profit-sharing plans -- whether they give you a relatively modest discount when you buy company stock or substantial numbers of stock options -- can give your retirement portfolio a considerable boost. They're great if the company prospers. But concentration of a big part of your retirement portfolio in a single stock also increases your risk. Companies sometimes fail or simply hit bad patches -- just ask anyone who had the misfortune to retire from IBM while that company's stock was in the dumps. That doesn't mean you should opt out of the profit-sharing plan -- it's likely to be extremely rewarding in the long run. But even with 20 years to retirement, you may want to reduce your overall risk by moving some of the money in your 401(k) portfolio from stocks to bonds. That may lower your overall return, but it will also increase the predictability of that return.
Years to retirement: 20 or more
Profile: You've got profit sharing at work and by the time you retire you'll own your home free and clear, so your 401(k) won't be your total nest egg (besides Social Security).
Recommended allocation:
- 80% equities
- 20% 10-year Treasury bonds
Your home is one of your biggest financial assets. And thanks to financial products such as reverse mortgages, you can tap the equity in your home during retirement without having to sell or move. So it makes sense to include this asset in your financial planning. Real estate values respond very differently than the stock market. House prices don't fall much just because of a 10% stock market correction, for example.
Local economic factors are the most important -- a boom in Denver can increase prices there even when nothing is happening in other markets. All that makes your house a powerful force diversifying your portfolio and reducing its volatility over time. With a house in the mix, you can afford to put more of your 401(k) into equities.
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