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Two Things Your Asset Allocation Strategy Must Do

Asset Allocation Concept

Asset allocation is simply a fancy term, which answers the question: How should I invest my retirement account balance?

There are good and bad asset allocation strategies. The best strategies accomplish two things:

1. Diversity Investments, to Reduce Risk

2. Provide Suitable Investment Return Potential

Risk means the possibility of losing principal -- the amount you invest. Every investment has risk. Even keeping money in a bank account has risk. For example, if your bank fails and the U.S. Government does not guarantee your account, you may lose your money.

However, not taking suitable risk can be just as bad. Why? Over time, money loses purchasing power. This effect is known as inflation. We see inflation everywhere. Inflation is why a can of Coca-Cola cost $0.10 in 1960 and $1.00 today.

Generally, investments with greater risk tend to provide greater potential investment returns. If your investment returns consistently exceed the inflation rate, then your purchasing power increases over time. However, if your investment returns do not keep pace with inflation then you might need to find alternate sources of income, or your standard of living may decline over time.

There are many ways to calculate inflation, but a good estimate is the U.S. Consumer Price Index. Historically, the average annual change in the U.S. Consumer Price Index has been slightly more than 3%. This means that if a can of Coca-Cola cost $1.00 today, we could reasonably expect it to cost $1.03 one year from now.

In general, equity investments (stocks or stock mutual funds) provide the greatest return potential, but also carry the greatest risk. Fixed income investments (bonds or bond mutual funds) are generally less risky than stocks, but do not tend to provide as much investment return potential.

Cash equivalents, such as money market funds, are generally the least risky asset class, but also provide the least opportunity for investment returns. As an example, below is one investor's asset allocation strategy.

  Years to Retirement
Asset Class 40+ 40 to 20 20 to 10 10 to 5 5 to 0
Equity Investments (Stocks) 100% 80% 60% 40% 20%
Fixed Income Investments (Bonds) 0% 20% 35% 50% 65%
Cash Equivalents (Money Market) 0% 0% 5% 10% 15%
Total 100% 100% 100% 100% 100%

Notice the asset allocation change as the investor approaches retirement. Generally, investors closer to retirement should be more conservative with their asset allocation strategy because they have less time to recoup potential investment losses. Likewise, investors further from retirement can generally assume more risk for potentially greater investment returns.

Knowing your retirement horizon is important before developing your personal asset allocation strategy. In addition, you should always consider investment objectives, risks, charges, and expenses before investing.

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