Long-term investments in the stock market have outperformed most other types of investments for the better part of a century, but the stock market can whipsaw up and down over the short term. Bonds tend to be less volatile, but their total return typically doesn't compete with stocks over the long haul. The U.S. Securities and Exchange Commission recommends including both stocks and bonds in your portfolio, but your asset mix will likely change over time.
Time is your greatest ally in the world of investing. When it comes to your asset mix, you can typically afford to be more aggressive with your investments when you are young. If you have another 40 years before you expect to retire, you might feel better about investing in a higher risk company that has the potential for a huge return, because if that company goes bust, you've got time to recover from the loss. The old-school rule of thumb is that the percentage of your investments that should be in stocks is 100 minus your age. Using that formula, if you're 27 years old, you should have 73 percent of your investment portfolio in stocks. The percentage shifts to more conservative levels as you age.
Your age is not a factor if you have a serious aversion to risk. If the thought of losing money in an aggressive growth mutual fund keeps you awake at night, the potential return on your investment might not be worth the aggravation. A conservative approach to asset allocation would be a better fit. While the American Association of Individual Investors advocates a 90/10 percent split between stocks and bonds for aggressive investors, the ratio shifts to 50/50 for conservative investors.
Stocks and bonds are not homogenous investments. Some stocks, such as old-line blue chips, are quite conservative, while others, such as microcap over-the-counter stocks can be speculative at best. U.S. Treasury bonds are among the safest of all investments, but low-rated junk bonds come with a high risk for default. When developing your asset mix strategy, the AAII suggests further breaking your stock and bond allocations into investment categories, such as large-, medium- and small-cap stocks; international stocks; emerging market stocks; intermediate-term bonds; and short-term bonds. Depending on your tax situation, you might want to include tax-exempt municipal bonds in your list. Conservative portfolios typically contain a higher percentage of large-cap stocks and short-term bonds, while aggressive portfolios include international and emerging market stocks and only a small percentage of intermediate-term bonds.
The stock and bond markets are not static. Market prices increase or decrease, sometimes widely, in the course of a single day. These price changes will affect the percentage mix of the assets in your portfolio. If you decide on a conservative approach, with a 50/50 mix, and the stock market soars, you might find the percentages in your portfolio have shifted to 65/35. The SEC recommends rebalancing your portfolio by selling some of your stocks and investing the proceeds into additional bonds to restore the appropriate mix.
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