The best way to determine how to allocate your investments is to first create a financial plan.
Don’t put all your eggs in one basket. It is one of the financial world’s oldest axioms and a simple principle we absolutely know to be true.
When it comes to “eggs” and “baskets” and building portfolios to last a lifetime, the decisions you make can be frustratingly confusing or refreshingly simple.
I prefer simplicity over complexity, so let’s get going. For most of us, the investment choices in our retirement plan accounts primarily consist of two baskets: stock and bonds.
Never satisfied with simplicity, the Wall Street crowd continues to complicate the matter by adding additional baskets like commodities, precious metals, alternative funds, market neutral funds, and hedge funds to the mix, when all you really need are stocks and bonds.
For today, let’s include real estate investment trusts in the “stocks” basket, and securities such as stable value funds and money market funds in the “bonds” basket, and
go from there.
The best way to determine how to allocate your investments in the two baskets of stocks and bonds is to first create a financial plan. This document will give you a good idea of how much you need to save (while working) and spend (during retirement), so that someday you can retire, confident that you won’t outlive your money.
Your financial plan will provide you insights on how inflation will impact your portfolio (encouraging more money allocated to stocks), but also how much the next bear market will impact your portfolio (suggesting you keep some dollars in bonds).
Don’t have time to create a financial plan? One solution is what’s known as allocating your age in bonds. For instance, if you are a 25-year-old just starting out in the workforce, directing 25 percent of your portfolio to bonds and the remainder to common stocks is a good place to start.
Time for a little detour here to remind everyone who is 25, 35, and even 45 years old that you should be concerned not with a steep stock market decline over the next four years, but with inflation harming your purchasing power over the next four decades. And never forget: With your best saving years likely in front of you, you should get depressed when the market goes up and rejoice when the stock market goes down.
The “age in bonds” rule has worked well for investors on the late end of the investing spectrum as well. Take for example the bear market of 2008. A 65-year-old investor would have had only 35 percent of his or her portfolio in the volatile stock market, significantly cushioning the blow of that nasty decline.
However, with interest rates today hovering near all-time lows, creating an intelligent allocation between stocks and bonds as you near retirement is more challenging than ever. Allocating 65 percent of your portfolio to bonds at current meager yields isn’t going to generate a whole lot of income.
This is where that financial plan of yours comes in handy. It allows you to determine whether it makes sense to allocate even more dollars to common stocks to capture the expected higher long-term returns of this basket.
For retirees, creating a financial plan provides clarity between the relationship of your cash flow needs and bear markets. Remember, bear markets in stocks are inevitable, but only detrimental if you are required to sell your stocks during market declines to cover your living expenses. Allocating at least eight to 10 years of cash flow needs into the bond basket reduces the likelihood of this occurring, allowing you to ride out those unpredictable stock market declines.
Despite the incessant Wall Street chatter of earnings reports and industry trends, the most important investing decision you will make is not what stocks to own, but how you allocate your portfolio between stocks and bonds. This decision is in your complete control, which means you are in charge of your financial destiny, not Wall Street.
You shouldn’t have it any other way.