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What You Should Know

Asset Allocation

How Much of Your Portfolio Should Be in Bonds?

The answer to this question depends on that asset allocation that is right for you, your goals, your age and your appetite for risk.

Asset Allocation

Asset allocation describes the percentage of total assets invested in different investment categories, also known as asset classes. The most common broad financial asset classes are stocks (or equity), bonds (fixed income) and cash. Real estate, precious metals and “alternative investments” such as hedge funds and commodities can also be viewed as asset classes.

Each broad asset class has various subclasses with different risk and return profiles. In general, the more return an asset class has historically delivered, the more risk that its value could fall as well as rise because of greater price volatility. To earn higher potential returns, investors have to take higher risk.

Asset classes differ by the level of potential returns they have historically generated and the types of risk they carry. Virtually all investments involve some type of risk that you might lose money.

Asset subclasses of stocks include:

  • Large cap stocks stocks of large, well established and usually well known companies
  • Small cap stocks stocks of smaller, less well known companies
  • International stocks stocks of foreign companies

Large cap, small cap and international stocks can in turn be considered:

  • Value stocks whose prices are below their true value for temporary reasons
  • Growth stocks of companies that are growing at a rapid rate.

Asset subclasses of bonds include:

  • Different maturities long-term (10 years or longer), intermediate-term (3-10 year) or short-term (3 years or less)
  • Different issuers government and agencies, corporate, municipal, international
  • Different types of bonds callable bonds, zero-coupon bonds, inflation-protected bonds, high-yield bonds, etc.

Risk

Stocks are generally considered a risky investment because, among other things, their values can decline if the stock market goes down (market risk) or the issuing company does poorly (company risk). As owners of the company, stockholders are paid after all creditors, including bond holders, are paid. In theory at least, a stock’s value can go to zero. Historically, stock prices have been the most volatile of all the different types of investments, meaning their prices can move up and down quickly, frequently and not always in a predictable way.

Bonds are considered less risky than stocks because bond prices have historically been more stable and because bond issuers promise to repay the debt to the bondholders at maturity. That promise is generally kept unless the issuer falls on hard times; some bonds have credit risk based on the financial health of their issuer. When a bond issuer goes into bankruptcy, bondholders are paid off before stockholders. Bonds are also vulnerable to interest rate risk: when interest rates rise, bond prices fall and vice versa.

Cash investments carry opportunity risk. For example, investing in very safe, short-term investments like Treasury bills may protect you from loss, but you may miss the opportunity of more generous returns offered by other investments. Even people who keep their money under their mattress have the risk that their money will be worth less in the future because of inflation that reduces the purchasing power of the cash.

Why Allocate?

Smart investors do not put all their assets in one type of investment or “asset class.” Instead, they spread or diversify their risk by investing in different types of investments. When one asset class is performing poorly, another may be doing well and compensating for the poor performance in the other.

Some studies have shown that overall asset allocation is more important to investment success than the choice of investments within the allocation.

“Model” Asset Allocations

Investment firms often publish recommended asset allocations based on their outlook for the relative performance of the stock, bond and money markets.

Personal finance Web sites and different types of investment advisers sometimes offer standard asset allocation recommendations for people of different age ranges or risk tolerance. The asset allocation that is right for you, however, depends on several personal factors, such as life and financial goals, and will change over time with different life events.

Personalize, review, revise as needed

Once you establish your optimal asset allocation which takes into account return objectives, risk tolerance and time horizon, you need to review your investments regularly to see if your portfolio matches your plan and if your plan is still right for your age and goals. When one asset class performs well or poorly, it can shift your asset allocation. You can bring it back in line by “rebalancing” or selling assets that have appreciated and buying those that have fallen in price. In this way, asset allocation enforces a good discipline of selling high and buying low.

Younger investors may want to allocate their longer-term retirement assets to riskier investments such as equities or stock, because they have time to ride out the market’s ups and downs. With age, however, asset allocations may shift toward safer investments such as bonds because retirement is getting closer and older investors should be more concerned about keeping what they have saved and gained.

Take time every six months to a year or two to be sure your asset allocation matches your plan and that your plan remains appropriate for your age and goals. If not, you may want to take the steps to make sure your plan is appropriate for your age and goals and balance your asset allocation to match your plan. Your investment advisor can help with this process.