One of the first decisions in the development of a long-term investment plan is to select an asset allocation strategy -- how to divide your investment money between the two major investment types of stocks and bonds. The best asset allocation for your portfolio depends on your personal financial situation and goals for the investment.
Stock investments are ownership shares of companies and provide the opportunity for long-term investment growth as the companies grow their businesses and profits. Stocks provide the potential for higher returns with a corresponding higher risk of losses. The longer the investment time frame, the greater the possibility that stock investment will produce significant portfolio growth. Bonds are debt securities that pay fixed rates of interest and return the principal amount when a bond matures. Bonds provide income and principal stability to a portfolio. Historically, the long-term return from bonds is less than from stocks, but in the short term stocks have produced periods of significant losses compared to bonds.
The Securities and Exchange Commission website lists your investment time frame and your risk tolerance as the two major factors used to determine a suitable asset allocation between stocks and bonds. A longer time frame allows you to overweigh with riskier stocks and invest through several up and down cycles for the eventual long-term gains. A shorter time frame points to a larger portion of more stable bond investments. Your risk tolerance determines if you can handle the paper losses associated with the down cycles in the stock market. With a high risk tolerance, you can put a larger portion of the portfolio in stocks. A low risk tolerance means the portfolio should have a higher proportion of bonds.
Use an online investment allocation tool to produce a starting point for your own asset allocation decisions. The tools take data about your current investment amounts, investment goals, time frame and risk tolerance to produce allocation percentages in different classes of stocks and bonds. The SEC Asset Allocation webpage provides a link to the asset allocation calculator of the Iowa Public Employees Retirement System. Some of the major online financial magazines also offer asset allocation calculators. The SEC website also suggests consulting with a financial professional if you are unsure where to start with your allocation decisions.
Personal, Rigorous and Flexible
The allocation between stocks and bonds for your portfolio should be based on your personal financial situation -- portfolio size, investment goals and knowledge. Once you have an allocation plan in place, the percentages in different assets should not change as the markets move up and down. Rebalancing to meet you allocation percentages allows you to buy low and sell high, smoothing out the long-term results. However, your allocation plan should be flexible enough to change if you situation changes or as you move through the different stages of your professional and personal lives.
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