3 asset allocation rules you should know by heart
The assets you accumulate in your lifetime can be used to benefit you in the near term as well as retirement, and knowing how to manage those assets will increase the likelihood of them serving you well. With that in mind, here are a few rules to stick to if your goal is to grow wealth successfully.
1. Don't invest money in stocks you expect to need within seven years
The stock market can be extremely volatile. Political news, weather events, and, as evidenced by the COVID-19 outbreak, devastating pandemics can take an otherwise stable market and turn it on its head. That's why as a general rule, you should only invest money in the stock market that you don't expect to use for seven years or longer. If you invest money that you wind up needing a year or two after the fact, you'll increase your risk of having to liquidate assets when their value is down, thereby locking in losses. On the other hand, if you give yourself a longer investment window, you'll be better positioned to ride out stock market downturns.
2. Diversify within different asset classes
The assets you acquire can take on different forms, but the three common ones include stocks, bonds, and cash. Within each category, however, is the opportunity to diversify, and it pays to do so to limit losses and increase your gains potential.
If you're looking to load up on stocks, for example, you might consider a mix of value stocks, which are stocks issued by companies that are perceived to trade at a lower value than what comparable stocks trade at, and growth stocks, which are stocks issued by companies that are growing faster than the average company. It's also a good idea to invest in different segments of the market. For example, rather than load up a portfolio with energy stocks alone, you might buy some of those, but also acquire some health stocks, auto stocks, bank stocks, retail stocks, and utility stocks.
Bonds, meanwhile, come in a few different varieties. Treasury bonds are extremely low-risk, while municipal bonds offer tax incentives that make them an attractive option. Corporate bonds are riskier than Treasury and municipal bonds and don't come with tax breaks, but they tend to offer higher yields. Bonds also come with terms that vary in length, and another good way to diversify is to ensure that yours mature at different intervals -- say, buy short-term bonds that come due in five years, but also, some long-term bonds that mature in 10 years or longer.
The one asset class that's not so easy to diversify in is cash -- but you can still spread your cash around by putting some in a savings account and the rest in a certificate of deposit.
3. Figure out your personal tolerance for risk
There are different rules of thumb you can follow when deciding how to divvy up your assets, and a popular one is the rule of 110. It states that to figure out how much of your portfolio should be in stocks, subtract your age from 110. If you're 40, you can keep 70% of your assets in stocks, and leave the rest in bonds and cash.
But that rule shouldn't be taken as gospel, and your personal risk tolerance should heavily dictate how your assets are allocated. If you have a high risk tolerance at age 40, you might decide to put 90% of your assets in stocks. If you have a low risk tolerance, you may not be able to sleep at night knowing you have 70% of your portfolio in stocks, in which case that's not the right percentage for you.
Knowing how to property allocate your assets could help you meet your near- and long-term financial goals. Follow these rules, especially if you're just getting started with investing, but remember, you're allowed to tweak them along the way as your circumstances change and your personal knowledge base continues to expand.