Let's review what we've covered thus far. We looked at how your asset allocation goals are determined by your mix of financial goals, risk tolerance and investment horizon.
We looked at how making reasonable estimates of investment returns and inflation, as well as understanding the impact of taxes, are important to your decisions. We also looked at the major asset classes and some of the investment categories available within each of them.
The next step is to set up an initial allocation. Consider using a four-step process similar to this: List current investments. Write down how your investments are currently allocated. Include the market values and weightings of each investment. This list is your current allocation. For example, your current allocation for a $100,000 portfolio might look like this:
|Checking and savings||$5,000||5%|
|Money market account||$5,000||5%|
|Value stock mutual fund||$10,000||10%|
|Growth stock mutual fund||$20,000||20%|
|Income stock mutual fund||$20,000||20%|
|Government bond fund||$15,000||15%|
|High-yield bond fund||$5,000||5%|
Double-check your risk tolerance, investment horizon and financial goals. You may wish to refer to the topics on risk tolerance and investment horizon in this educator.
Generally, conservative investors own portfolios more heavily weighted towards bonds and cash. Aggressive investors, on the other hand, have a larger weighting in stocks. Remember, the longer your investment horizon, the more aggressive you can afford to be.
Review your assumptions. Over time, stocks have earned a much higher rate of return than bonds and cash. According to data from Ibbotson Associates' 2007 Yearbook of historical returns, stocks -- as represented by the S&P 500 index -- averaged an annual rate of return of 10.4 percent over the 81 years ended in 2006.
Over the same period, Ibbotson found that intermediate-term bonds averaged an annual rate of return of 5.4%, and cash (as represented by Treasury bills) averaged an annual return of 3.7%.
This means that even the most conservative of investors need to allocate some of their portfolios to stocks if they expect significant growth in their portfolios. It's also important that conservative investors have lower expected returns than aggressive investors.
If your financial goal is to save for retirement, you should estimate your expected income needs and expenses in retirement as carefully as possible. Avoid overly optimistic projections of your life span, inflation and future rates of return.
Careful planning now will save you later. If your portfolio has a lower-than-expected return year after year, you may have to increase your aggressiveness in the future to catch up. Most of us do the opposite as we get older. Making poor estimates today may result in a smaller portfolio tomorrow, forcing you to be aggressive late in life to make up for lost time.
If your financial goal is to save for a child's education, you will want to carefully estimate the future cost of tuition and board.
Pick a portfolio that matches your asset allocation. After you've quantified your risk tolerance and investment goals and double-checked your estimates, you want to buy securities in a proportion that mirrors your initial allocation. In the process, you may find yourself selling some investments in order to achieve the targeted initial allocation.
The following table shows some a potential range of initial allocations that may apply. You may wish to check with a financial adviser. For example, an aggressive investor might invest 70 to 90 percent of their portfolio value in stocks, while a conservative investor might only invest 30 to 50 percent in stocks: