Asset allocation involves diversifying your retirement account across stocks, bonds, and cash. Age is a crucial factor to consider when managing asset allocation, as your ability to take investment risks decreases as you get older. As retirement approaches, wild swings in the stock market can be detrimental to your financial goals, making it essential to avoid risky investments.
To optimize your asset allocation strategy and meet your retirement objectives, here are five best practices to follow:
- Adjust your asset allocation according to your age
When your investment timeline is short, market corrections can be both emotionally and financially problematic. Emotionally, a market downturn can cause stress, especially if you had plans to use that money soon. Financially, selling your stocks at the bottom of the market locks in your losses and puts you at risk of missing out on potential recoveries.
Adjusting your allocation according to your age can help you avoid these issues. For instance:
- If you are younger than 50 and saving for retirement, you can consider investing heavily in stocks. You have enough time until you retire and can ride out any current market turbulence.
- As you approach your 50s, consider allocating 60% of your portfolio to stocks and 40% to bonds. You can adjust these percentages based on your risk tolerance. If you are uncomfortable with risk, decrease the stock percentage and increase the bond percentage.
- Once you retire, you may prefer a more conservative allocation of 50% in stocks and 50% in bonds. Again, adjust this ratio based on your risk tolerance.
- Hold any money you will need within the next five years in cash or investment-grade bonds with varying maturity dates.
- Keep your emergency fund entirely in cash, as emergencies require immediate access to funds.
Translation to SCI paper format:
Asset allocation involves diversifying your retirement account across stocks, bonds, and cash, with age being a crucial factor to consider when managing allocation. As individuals get older, their ability to take investment risks decreases, and avoiding risky investments is essential to achieving retirement goals. This article presents five best practices for optimizing asset allocation strategies.
- Consider your risk tolerance, not just your age
You may have heard of age-based asset allocation guidelines such as the Rule of 100 and Rule of 110. The Rule of 100 advises holding a percentage of stocks in your portfolio by subtracting your age from 100. For example, if you are 60, the Rule of 100 advises holding 40% of your portfolio in stocks.
The Rule of 110 works the same way, but you subtract your age from 110 instead of 100. This rule is based on the idea that people are living longer now.
However, age and time to retirement are not the only factors to consider when determining your ideal asset allocation. Your risk tolerance is also important. Ultimately, diversification across asset classes should provide you with peace of mind, regardless of your age.
If you are 65 or older, already receiving Social Security benefits, and experienced enough to stay calm during market cycles, then you may want to consider purchasing more stocks. If you are 25 and market corrections cause you to panic, then aim for a 50/50 split between stocks and bonds. You may not achieve the highest returns, but you will likely sleep better at night.
- Do not let stock market conditions dictate your allocation strategy
When the economy is doing well, it may be tempting to believe that the stock market will continue to rise indefinitely. This belief may encourage you to hold more stocks to chase higher profits. However, this is a mistake. It is important to follow a planned asset allocation strategy precisely because timing the market is not possible, and nobody knows when a correction will occur. If you allow market conditions to influence your allocation strategy, then you are not truly following a strategy.
- Diversify your holdings within each asset class
Diversification across stocks, bonds, and cash is essential, but you should also diversify within these asset classes. Here are some ways to accomplish this:
Stocks: Hold 20 or more individual stocks or invest in mutual funds or exchange-traded funds (ETFs). You can diversify your stock holdings by individual company and market sector. Utility companies, consumer staples, and healthcare companies tend to be more stable, while the technology and financial sectors are more reactive to economic cycles. Mutual funds and ETFs are already diversified, which makes them an attractive option when working with small dollar amounts.
Bonds: Diversify your bond holdings by investing in bond funds or varying your holdings across bond maturities, sectors, and types. Municipal, corporate, and government bonds are the primary types of bonds available.
Cash: Cash does not lose value like stocks or bonds can, so diversifying your cash holdings is not always a priority. If you have a lot of cash, you may want to hold it in separate banks so that all of it is FDIC-insured. (The FDIC limit is $250,000 per depositor per bank.) Most people do not have a significant amount of cash, so you may want to diversify how you hold your cash to maximize liquidity and interest earnings. For example, you could hold some cash in a liquid savings account and the rest in a less-liquid certificate of deposit (CD) with a higher interest rate than a typical savings account.
- Consider investing in a target-date fund for automated asset allocation
If the idea of asset allocation makes you drowsy, there is an alternative: investing in a target-date fund that manages asset allocation for you. A target-date fund is a mutual fund that holds multiple asset classes and gradually adjusts towards a more conservative allocation as the target date, typically the year of retirement, approaches. For instance, a 2055 fund is intended for individuals planning to retire in 2055.
Target-date funds generally follow allocation best practices, diversifying across and within asset classes while taking age into account. These funds are also low maintenance since you do not need to manage your allocation actively or hold other assets except for your emergency fund.
However, target-date funds do have limitations. They do not consider your individual risk tolerance or potential changes in your circumstances. For example, a significant promotion may enable you to retire earlier than expected, requiring a review of your portfolio’s allocation to determine if it is still appropriate.
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Asset allocation is not a one-size-fits-all approach. Your unique financial situation and investment goals should inform your decisions around asset allocation.
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