There are only a few investment decisions that really matter.
And of course, what you actually choose to invest in is right up there.
What might surprise you is that the specific investments you choose matter less than the types of investments you choose. That is, investing in the stock market at all has a bigger impact on your return than the specific stocks or mutual funds you pick.
So, how do you choose the right types of investments for your specific goals? This post will walk you through the decision.
What Is Asset Allocation and Why Does It Matter?
Asset allocation is the fancy term investors have given to the process of dividing your money up across the various investment categories like stocks, bonds, and cash.
And it’s important because how you choose to mix and match these different types investments is the primary way you exert control over two big things:
- Your investment return
- Your investment risk
This one decision does more than any other to determine both how much money you could earn and the probability of actually earning it.
What Types of Things Can You Invest In?
Given the importance of this decision, how do you determine the right mix of investments for your specific goals?
The first step is simply understanding your options. And while no two investments are exactly the same, we can group most investments into a small set of broad categories that share similar characteristics.
An investment’s category tells us a lot about how we can expect it to perform. Here’s how each of the major investment categories affects your overall plan.
A single stock represents a piece of ownership in a company, and the value of that stock rises and falls based on the success of that company.
Stocks have the highest expected return out of all the traditional investment options, but they also come with the biggest downside risk.
For example, U.S. stocks have returned 9.5% per year over the past 87 years, but have also experienced annual declines as big as -43.84%.
Cash includes things like savings accounts, CDs, and money market funds.
These investments offer the lowest possible return of all the major options, but also the lowest downside risk. In fact, many cash investments (like FDIC-insured savings accounts) are guaranteed to keep your money safe.
Bonds offer a middle ground between stocks and cash.
A bond is technically a loan you give to an organization in exchange for interest. And bonds offer a medium expected return with a medium level of risk.
For example, U.S. government bonds have returned 5.23% per year over the past 87 years, but have also experienced annual declines as big as -11.12%.
There are plenty of other types of investments, from real estate, to commodities, to options, and others.
Each of these types can be helpful in the right situations, but they aren’t necessary and often cause problems when they aren’t used correctly. For those reasons they won’t be considered in the rest of this post.
Need vs. Ability
Your job is to mix and match the options above to create an investment plan that helps you reach your personal goals. That is, what percentage of your investment money will you put into stocks vs. bonds vs. cash?
While that might sound daunting, it can actually be broken down into a few small decisions.
To start, here are three ways to think about how much risk you should take on.
1. Return Needed
What level of investment return do you need to reach your goal? If it’s low, you may be able to stick primarily to conservative investments like cash and bonds and take some of the risk off the table.
2. Risk Capacity
Financial planner Michael Kitces defines risk capacity as the extent to which “a ‘risky event’ [could] happen (e.g., a market crash) without damaging the underlying financial goals.”
For example, a 20-year-old investing for retirement typically has greater risk capacity than a 60-year-old, since there is more time to make adjustments if things don’t go according to plan.
The higher your risk capacity, the more room you have to reach for the higher returns of the stock market without fearing the potential negative consequences.
3. Risk Tolerance
On the other hand, risk tolerance measures your personal comfort level with risk. Some people are fine with the big ups and downs of the stock market, and others aren’t.
And since sticking to your plan is one of the most important factors for investment success, knowing ahead of time what you’re comfortable with will help you get better results.
Vanguard has a risk tolerance questionnaire that can help you figure this out.
Two Rules of Thumb
The three guidelines above can help you understand whether you’re able to take on more or less risk, but still, what does that mean in terms of actual numbers? What percent of your investments should you put into each category?
Here are two rules of thumb you can use to help you decide.
First, the younger you are, the more likely it is that you’ll want some significant portion of your investments in the stock market. This is both because stocks offer the best opportunity for long-term growth and because you have more time to make adjustments if things go awry. Holding 60% to 90% stocks is a common range for people in their 20s to 40s.
(Of course, even those of you near or in retirement likely want some money in the stock market.)
Second, in a worst-case scenario, expect that you could lose 50% of the money you have in the stock market in any given year. So if you have 70% of your money in stocks, you may face a 35% loss in a single year.
You would of course also expect your account value to recover over time, but this gives you a sense of the downside risk you might face.
Finally, remember that there is no right answer here. The most important thing you can do right now is make a reasonable choice based on the factors above, and start saving money. You can always make adjustments later if needed.
Matt Becker is a fee-only financial planner and the founder of Mom and Dad Money, where he helps new parents take control of their money so they can take care of their families. His free book, The New Family Financial Road Map, guides parents through the all most important financial decisions that come with starting a family.