Asset allocation in investing refers to how much of your money is kept in different investment types — stocks, bonds, or cash. There are other asset classes like real estate and commodities, but stocks, bonds, and cash are typically the core options in your 401(k) and what most people use in building a nest egg for retirement.
Experts and respected studies show that other than making the decision to invest that your asset allocation is the next most important decision you’ll have to make. To build your nest egg over time, you need to consider some important performance facts. Since 1926, U.S. large cap stocks (e.g. the S&P 500) have delivered 10.0% returns annually, long-term government bonds 5.5%, and cash 3.3%. And since 1960, inflation has averaged ~4% a year. Currently, interest rates on cash are very low, and inflation is half of the historic average. It stands to reason that a sizeable amount of your investment ought to be in stocks to build up your retirement account. Read on as there is more to consider.
You might think, given the fact that stocks have historically provided better returns than bonds and cash, why wouldn’t I just put all my retirement savings into stock funds? There are two answers to this question:
- First, there’s no guarantee of future returns. Past results are not a guarantee of future results. Diversifying across asset classes can offer assistance as one class may perform while another suffers in differing economic environments.
- Second, stocks have had years when returns increased greater than 20%, and periods where they have declined 20% or more. Those are big swings.
Think about 2020. The stock market tumbled over 33% by March, only to quickly rebound and have strong returns by December. That was a wild roller coaster. In March of 2020, you might have felt like you lost a lot of money, and then a year later, you might be psyched. Just know that stocks are likely to go up and down at a much greater percentage than bonds and cash.
Because the stock market is volatile, and bonds can be worth more in periods when stocks are going down (and vice versa), investing a percentage of your savings away from stocks is a good idea. You’d hate to reach retirement age at a time when stocks are down significantly, and you have no other investments, so you take real losses on your investments. Remember, there are no true gains or losses until you sell an investment.
Put Time on Your Side
Generally, the more time you have until retirement, the more time you have to navigate through market ups and downs. A person in her mid-twenties might consider investing more in stocks — upwards of 90% — and just 10% in bonds. A person who is 62 and will be retiring in three years may be better served with an allocation of 60% in stocks and 40% in bonds. Remember, even at 65, you will be relying on your savings for 15 to 30 years or more. So, you still have time to have some money in stocks and ride out the inevitable market potholes in the road ahead. To figure out the right asset allocation for yourself, you’ll need to think about your risk tolerance.
What’s Your Tolerance for Risk? Consider It and Manage to It
When it comes to investing, it’s extremely important to know yourself. If you’re uncomfortable seeing your savings swing with the markets or lose value for a period of a year or more, you should build a more conservative portfolio comprised of perhaps 60 to 70% in bonds and 30 to 40% in stocks. If you take a conservative approach, you won’t likely reach you goals quite as fast, but you’ll likely sleep a whole lot better at night. You’ll want to think about how much more to contribute if a conservative approach fits you. If you are comfortable riding the big waves, allocating much more in stocks than bonds will be for you. There is no right or wrong answer, it’s just knowing and figuring out what puts you on the right course to meet your goals.
Not Sure Which Funds to Pick in Your 401(K)?
At ShareBuilder 401k, if you are comfortable picking your own investments, you can pick from a carefully curated list of funds by asset class. But if you are new to investing or prefer experts manage your allocation, simply pick one of our model portfolios. The model portfolios range from stable to aggressive, so you can find the one that best describes you as a person and select it. If you don't have model portfolios in your 401(k) plan, you may want to consider a target date fund. Target date funds aren't as precise in considering your risk tolerance versus a model portfolio, but it can be a good way to get started when there aren't model portfolios.
Bonus Tip: Auto-Rebalance
Each day, month, and year, stocks and bonds will perform differently. This will push your portfolio allocation off from what you’d originally setup. It’s good to let assets move a bit as they will over a period and then to rebalance back to the allocation amount you prefer. Rebalancing helps you manage risk and to stay on strategy versus letting your investment drift over years and potentially put you at greater risk during volatile times. Many providers offer a feature called auto-rebalancing, so you don’t need to continually watch and calculate this on your own manually. Quarterly auto-rebalance is a good method and frequency to manage your asset allocation. So, select auto-rebalancing and put this piece on autopilot, and then each year, revisit your risk tolerance and adjust your asset allocation as needed to fit you.