Asset allocation is the most important component of investing, more so even than individual investment selection. This is even more true since most individual investments are “market sensitive,” which is to say their performance is largely determined by the direction of the overall markets.

It’s your allocation in those markets that will have the greatest impact on your investment returns over the long haul.

Rules of Thumb for Asset Allocation

Most of us like to have a formula—a “rule of thumb”—that takes the guesswork out of asset allocation. Fair enough. But rules of thumb are more theory than rule because a host of individual factors can and should play into your investment mix.

All the same, it doesn’t hurt to review the best known rules. You may decide to ignore them, but you’ll have done your due diligence.

Fixed Allocations

Because it’s so customized, this more a strategy than a rule of thumb. But it’s the simplest method because you set it once, then forget it. All you do is decide early on that you’re going to maintain a specific stock-bond-cash investment mix—say 60-30-10, 70-25-5, 50-35-15—then, you keep it for life.

The theory behind this method is that investment allocations don’t, and shouldn’t, change much over the course of your life. Even when you retire, you’ll still need to invest for growth to fund a retirement that will last 20 or 30 years. That will make an outsized stock allocation necessary throughout your life.

100 Minus Your Age = Your Stock Allocation

This is the granddaddy of stock allocation principles, and it’s been around since before anyone can remember. Using this “rule,” a person who is 40 years old would allocate 60 percent (100 – 40) of his portfolio to his stock position. The attraction of this rule is its simplicity and the fact that it’s a virtual sliding scale that can work at any age and without a lot of thought. That, after all, is what we expect from rules of thumb.

But as simple as the rule is, and as enduring as it’s been, it has a few holes—big ones. For one, it doesn’t tell us what we should do with the rest of our money, the part we don’t put into stocks. For another, it was conceived at a time when people didn’t live as long as they do today. Longer lifespans require more aggressive stock allocations.

120 Minus Your Age = Your Stock Allocation

This is an update of the rule above. It still doesn’t tell us where to invest the portion of our money that isn’t in stocks but it does take longer life spans into account. The same 40-year-old in the example above would allocate 80 percent of his portfolio to stocks (120 – 80), reflecting a larger investment in risk investments to compensate for his longer life.

There are various other rules of thumb, many involving fairly complex math equations, but any asset allocation method that doesn’t take personal factors into consideration is doomed to fail no matter how good it may sound or look on paper.

Time Horizons and Risk Tolerance

The first two rules address the issue of your time horizons, but do so over the course of a lifetime. But investment time horizons aren’t specifically determined by age and longevity.

For example, if you’re investing for a shorter-term goal, such as early retirement or a child’s education, your time horizon may be just 10 years, even though you’re only 40 years old. Shorter time horizons mean lower stock allocations—and that difference doesn’t fit neatly within a global rule of thumb.

Risk tolerance is another major factor that isn’t adequately addressed by these rules. Many people have think they have high risk tolerance until they start losing money—and learn that they really don’t have it at all. You can’t truly address this issue unless you’ve actually experienced a large drop in your investments. If you haven’t you really have no basis to determine your risk tolerance. Which brings up another allocation rule of thumb that’s anything but mathematically precise.…

‘Invest Down to the Sleeping Level’

It may have been Burton Malkiel who first coined this term in his classic investment book A Random Walk Down Wall Street. This recommendation takes aim at the emotional side of asset allocation strategy, namely that you shouldn’t keep any more in risk investments than you can handle and still sleep soundly at night.

There are no numbers involved in this allocation—the “rule” is that you lower your stock allocation until it isn’t keeping you awake at night. You might have to spend some time working this one out, but it’s solid.

The Asset Allocation Counter-Rule of Thumb

If you want to use a rule of thumb as a guide to help you with your asset allocations, but feel that the rule overestimates your tolerance for risk (stocks), you do have some wiggle room: You can allocate within investment categories.

All stocks don’t behave in the same way—each carries varying degrees of risk—and you can diversify within your stock allocation to lower that risk. Some stocks are fairly low risk, such as dividend stocks, utility stocks and mutual funds that emphasize both growth and income. Stocks that have a long history of paying substantial dividends are hybrids between stocks and bonds, staying in tighter price ranges while providing regular income.

By keeping a percentage of your stock position in lower-risk stocks, you can work within both the chosen rule of thumb allocation and your own risk tolerance. Asset allocations rules of thumb are just guidelines. They can—and should—be customized to fit your preferences.


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