Sunday, December 26, 2010

How Much Should You Invest in Stocks and Stock Mutual Funds?

Asset allocation involves spreading your investments across diverse asset classes in an attempt to reduce the overall portfolio risk, while maintaining or increasing expected portfolio return. In other words, everything doesn’t go up and down at the same time. Some investments zig, while some zag, and the net result is smoother investment portfolio performance.
Two significant academic studies performed within the last 20 years overwhelmingly concluded that more than 90 percent of a portfolio’s long-term variation in return was explained by its weighting between stocks, bonds, and cash; in other words, it's more important that you have investments in stocks than which individual stocks you own or when you bought them. Only a small portion of the returns were explained by the investment manager’s individual investment selections. Asset allocation decisions are the fundamental building blocks on which all good portfolios are designed.
Figuring out the appropriate asset allocation for your portfolio depends on your unique circumstances. To get started, check out the following tables, which focus on your time horizon, tolerance for investment risk, and, of course, your personal goals. In order to determine the appropriate asset allocation for your needs, you must take into account all three of these components.
Use the Time Horizon and Equity Exposure table as a guideline that tells you how much of your total investments should be in stocks or stock mutual funds based on when you’ll need this money. Think of time horizon as the date that you need to withdraw those dollars from your investment portfolio to support your standard of living in retirement. For example, if you’re 60 years old right now and plan to retire in five years, your time horizon isn’t five years. Your time horizon begins five years from now and may go for two to four decades — for the rest of your life. So, the first withdrawal you make does have a time horizon of five years. The next annual withdrawal you make has a time horizon of six years, and so on.
Time Horizon and Equity Exposure
Time Horizon* Maximum Equity Exposure
0–3 years 0%
4–5 years 20%
6 years 30%
7 years 40%
8 years 50%
9 years 60%
10 years 70%
11+ years 80%
* When you need to spend this money.
The Risk Tolerance and Equity Exposure table gives you the lowdown on how much of your total investment portfolio should be invested in stocks or stock mutual funds based on the maximum amount of money you can handle losing — both financially and emotionally.
Risk Tolerance and Equity Exposure
Maximum Tolerable Loss (Annual) Maximum Equity Exposure
5% 20%
10% 30%
15% 40%
20% 50%
25% 60%
30% 70%
35% 80%
40% 90%
50% 100%

After looking at these tables, you may discover that the maximum equity exposure will be different depending on your time horizon and your maximum tolerable loss in a given year. If you discover a discrepancy between the maximum equity exposures for your time horizon and your maximum tolerable loss in a given year, select the lower of the two equity exposures.

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