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.
* 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.
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.
Other How To's
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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* | 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% |
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.
| 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% |
Other How To's
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- financial-measures-to-consider-before Investing
- Important-numbers-to-review-before Investing
Investing Glossaryaccredited investor
An individual with net worth of more than $1 million (alone or jointly with a spouse) or with income of $200,000 in each of the past two years and with a reasonable expectation of the same level of income in the current year. Certain higher-risk investments are often restricted to accredited investors.
Investing Glossaryalpha
A risk-adjusted measure of performance. Alpha measures the portion of an investment’s return attributable to the security’s inherent values (for example, earnings growth) rather than to overall market movements.
Investing Glossaryarbitrage
A trading technique that takes advantage of price discrepancies when the same security, currency, or commodity is traded on different markets.
Investing Glossaryat the money
A condition that is met when an option’s strike price is the same as the prevailing price for the underlying stock. For example, if stock ABC is trading at $125 and the option’s strike price is also $125, then the option is at the money.
Investing Glossarybalance sheet
A financial statement that shows the value of a company’s assets, liabilities, and owner’s equity on a given date. Total assets minus total liabilities equals owner’s equity.
Investing Glossarybeing short
A situation that occurs when you have sold something you do not own. In commodities, if you enter into a contract to sell a commodity which you don’t own with a promise to deliver it at a set price on a future date, then you are short that commodity. In stocks, you are short a stock if you have sold it and borrowed the shares from a broker to deliver to the purchaser, with an obligation to replace the borrowed shares at a future date. Being short means that you’re bearish, or negative on the market, and that your goal is to make money when the security or commodity that you choose to short falls in price.
Investing Glossarybeta
A measure of a stock’s relative volatility. A stock with a higher beta can be expected to rise or fall more than the overall market, whereas a stock with a lower beta is less volatile than the overall market.
Investing GlossaryBlack-Scholes model
A theoretical model used to calculate the fair market value of an option based on time to expiration, price of the underlying stock, historical volatility, strike price, and carrying costs.
Investing Glossarycall option
A contract that gives the holder the right to buy a particular asset at a specified price at any time prior to the expiration of the option.
Investing Glossarycallable bond
A bond that the issuer can redeem before its maturity date. The bondholder is often paid a premium when the bond is called.
Investing Glossarycandlestick
A chart that shows the daily high, low, opening, and closing prices for a security over a specified time period.
Investing Glossarycapital gain
The profit from the sale of an investment at a price that’s higher than the purchase price.
Investing Glossarycertificate of deposit; CD
An interest-bearing investment issued by a bank. CDs are typically available with maturities ranging from three months to five years.
Investing Glossarychurning
Buying and selling securities by a broker for the sole purpose of generating commissions.
Investing Glossarycovered call
A call option written by an investor who already owns the underlying shares. If you write a covered call and the option is exercised by the holder, then you would just deliver the stock to the holder.
Investing Glossarydelta; hedge ratio
Delta represents the price change of an option for every one-point change in the price of the underlying security or futures contract.
Investing Glossaryderivative
A financial instrument whose value is based on the value of another asset or index. A stock option, for example, is a type of derivative that gives you the right, but not the obligation, to buy shares of the stock at a predetermined price. The option’s value changes in relation to the price of the stock.
Investing GlossaryDesignated Order Turnaround system; SuperDOT
An electronic order-routing system used by NYSE member firms to send market and limit orders directly to the specialist at the exchange who trades that particular security.
Investing Glossarydividend
Money paid out by a company to the owner of its stock. An income stock is a stock that has a regularly paid, higher-than-average dividend.
Investing Glossaryequity market; stock market
A market in which stock shares are issued and traded. Trading takes place through both exchanges and over-the-counter markets.
Investing Glossaryexchange-traded fund; ETF
A mutual fund that is traded, like stocks, on an exchange.
Investing Glossaryfiat money
Currency that a government declares to be legal tender, even though it is not backed by reserves of physical assets (such as gold). The value of fiat money derives solely from the public’s confidence and faith in its ability to serve as a storage medium for purchasing power. Most of the world’s money is fiat money.
Investing GlossaryFinancial Industry Regulatory Authority; FINRA
The largest non-governmental regulatory organization responsible for overseeing all securities firms that do business in the United States. Responsibilities include professional training, testing and licensing of registered representatives, and arbitration and mediation.
Investing Glossaryforeign currency trading; forex
Speculation on the value of one currency versus another, in which you buy one country’s currency—just as you’d buy a stock or other security—in the hope that it will appreciate relative to the value of another currency.
Investing Glossaryfutures
Contracts where you agree to buy or sell a specific amount of a commodity, currency, or other asset at a specified price on a specified future date. Unlike an option, a futures contract creates an obligation, rather than just a right, to buy and sell the underlying security.
Investing Glossarygoing long
When you own a security or other asset, you are said to be long that security. When you go long (that is, buy) a security, you’re bullish, or positive on the market, and you expect the price of that security to go up.
Investing GlossaryGovernment-Sponsored Enterprise; GSE
Privately held corporations created by Congress to work for the common good—generally to facilitate borrowing for homeowners, farmers, and other specific groups. Examples of GSEs include Fannie Mae, Freddie Mac, and the Federal Farm Credit Bank.
Investing Glossaryhead-and-shoulders pattern
A chart formation in a graph of an asset price that resembles three mountaintops in a row, with the middle mountaintop being taller than the other two. The pattern indicates a trend reversal, meaning that prices are expected to fall.
Investing Glossaryhedge
An investment strategy that allows you to reduce the risk of an unfavorable price change in a security or commodity. For example, a stockholder of ABC Company who is worried about declining stock prices can offset that risk by buying a put option on ABC, allowing him to sell his shares in the future at today’s price.
Investing Glossaryilliquid securities
Investments that don’t trade very actively and are difficult to sell on short notice.
Investing Glossaryimplied volatility
A theoretical value representing the volatility of the security underlying an option. Implied volatility is used by the Black-Scholes model, among others, to calculate the price of an option. Implied volatility usually rises when the markets are in downtrends, and falls when the markets are in uptrends.
Investing Glossaryin the money
A condition that is met when a call option’s strike price is below the prevailing price for the underlying stock. For example, if stock ABC is trading at $125 and the option’s strike price is $120, then the option is in the money. For a put option, the strike price must be above the current market price of the stock for the option to be in the money.
Investing Glossaryindex fund
A mutual fund designed to mirror the performance of a specific market index such as the Dow Jones Industrial Average or the S&P 500. Expenses of index funds tend to be lower than other mutual funds because the manager is not actively researching, buying, and selling securities.
Investing GlossaryIndividual Retirement Account; IRA
A type of individual retirement savings plan. There are several types of IRAs, including, among others, Traditional IRAs and Roth IRAs. Traditional IRAs are tax-deferred accounts that currently allow individuals to contribute up to $5,000 per year. Contributions to a Traditional IRA may be tax deductible, depending upon several factors. You don’t pay taxes on the income and gains you generate in a Traditional IRA until you make withdrawals; all withdrawals will be taxed at the ordinary income tax rate. Roth IRAs are subject to different tax treatment.
Investing Glossaryleverage
The degree to which an investor or business is utilizing borrowed money. For investors, leverage is a means of multiplying the return on an investment by borrowing money to purchase additional securities or other assets. Buying securities on margin is an example. If you have $1,000 of cash and borrow another $1,000 from your brokerage, you could then purchase $2,000 of stock. If the value of the purchased stock increases by 10 percent ($200), then you have realized a 20 percent gain ($200/$1,000) on your actual cash investment.
Investing Glossarymarket capitalization; market cap; cap
The value of a company as measured by the total number of stock shares outstanding times the market price of each share. For example, if company ABC has 20 million shares outstanding, and each share is currently worth $100, then the market cap for ABC is $2 billion. In general, stocks are classified as large cap (over $5 billion), small cap (under $1 billion), or mid cap (anything in between).
Investing Glossarymarket-value weighted index
A stock index where the effect of each stock on the index is in proportion to its market value.
Investing Glossarymegatrend
A major ongoing development that is expected to have significant implications for most (if not all) facets of society over an extended period of time. The aging of the American population is an example.
Investing Glossarymomentum
The perceived strength behind a price or volume movement in a security based on the rate of acceleration of that movement.
Investing Glossarymoving average
In technical analysis, a chart line that shows the average of a security’s price over a specified period of time, recalculated for each new data point. For example, a 30-day moving average will include yesterday’s price and those for the previous 29 days. Tomorrow’s moving average will include today’s price but will drop the price for the earliest date in yesterday’s average. The moving average is used to spot pricing trends by flattening out large fluctuations.
Investing Glossarymunicipal bond; muni
A bond issued by a local or state government or agency. Munis generally raise money for public projects such as hospitals, roads, bridges, and sewer systems as well as general governmental operations. When you buy a muni, the interest is usually exempt from federal income tax.
Investing Glossarymutual fund
A fund operated by an investment company that raises money from shareholders and invests that money in a group of assets in accordance with one or more stated objectives, such as income, growth, aggressive growth, and so on. A mutual fund may generally invest in stocks, bonds, options, futures, currencies, and money market securities in accordance with its stated parameters. All shareholders share equally in the income, gains, and losses generated by the fund.
Investing Glossarynaked call
A call option written by an investor who does not already own the underlying shares. If you write a naked call and the option is exercised by the holder, then you would have to buy the stock at the market price to meet your obligation. Naked calls are very risky, though potentially very rewarding.
Investing GlossaryNational Association of Securities Dealers Automated Quotation system; Nasdaq
An electronic stock exchange established by the National Association of Securities Dealers (NASD). The Nasdaq lists over 3,200 companies and is the largest equity securities trading market in the U.S.
Investing Glossaryopen outcry system
A system where traders on a trading floor or in a trading pit shout and use hand signals to make transactions or trades with each other.
Investing Glossaryoption
A derivative security that gives the holder a contractual right to buy or sell a set amount of a stock, commodity, or other asset at a specified price on or before the option’s expiration date. An option is purchased for a fee, called a premium.
Investing Glossaryoption buyer; holder
A person who is buying options. Call option holders have the right to buy a stipulated quantity of the underlying asset specified in the contract at a specified strike price. Put option holders have the right to sell the specified amount at the strike price.
Investing Glossaryout of the money
A condition that is met when a call option’s strike price is above the prevailing price for the underlying stock. For example, if stock ABC is trading at $120 and the option’s strike price is $125, then the option is out of the money. For a put option, if the strike price is below the current market price of the stock, then the option is out of the money.
Investing Glossaryover-the-counter market (OTC)
A securities market where trades are conducted by phone or computer network directly between dealers rather than on a physical trading floor. All bonds trade over-the-counter, as do unlisted stocks (generally, stocks of smaller companies that do not qualify for listing on an exchange).
Investing Glossarypremium
When you buy an option, the premium is the amount that you pay to the seller of the option.
Investing Glossaryput option
A contract that gives the holder the right to sell a particular asset at a specified price at any time prior to the expiration of the option.
Investing Glossaryreal estate investment trust; REIT
A company, usually traded publicly, that raises money from shareholders and invests that money in a portfolio of real estate properties. REITs are modeled after mutual funds, although the tax treatment of REIT income is different.
Investing Glossaryregression analysis
A statistical technique used to find the mathematical relationship between a dependent variable (such as a company’s stock price) and one or more independent variables (such as GDP, income growth, or inflation). Regression analysis is used to predict future values of the dependent variable based on changes in the independent variables.
Investing Glossaryretracement
A price movement in the opposite direction of the previous trend. When a price has gone too far and traders deem the security overbought or oversold, the price may stop rising or falling and move in the opposite direction for a period of time.
Investing GlossaryRoth IRA
A type of IRA in which contributions to the account are not tax-deductible, but qualified withdrawals are completely exempt from federal income tax.
Investing GlossarySecurities and Exchange Commission; SEC
A federal agency whose mission is to protect investors from fraud or other unlawful market activities.
Investing GlossarySecurities Investor Protection Corporation; SIPC
A nonprofit corporation created by Congress in 1970 to protect investors in the United States. SIPC insures the assets in investor accounts (up to certain maximum amounts) at registered brokerage firms in the event of bankruptcy of those firms.
Investing Glossarysell stop order
An instruction to a broker to sell a stock at the market price after the security has touched the specified stop price. A sell stop is always placed below the present market price and is usually designed to protect a profit or limit a loss.
Investing Glossarysentiment
The general feeling among investors as to which direction the stock market is heading. If the sentiment is that prices are going up, it is said to be bullish; if the sentiment is toward a downward movement, it is bearish. Investors base sentiment on market activity and movements in the prices of securities.
Investing Glossaryshort; short position
A situation that occurs when you have sold something you do not own. In commodities, if you enter into a contract to sell a commodity which you don’t own with a promise to deliver it at a set price on a future date, then you are short that commodity. In stocks, you are short a stock if you have sold it and borrowed the shares from a broker to deliver to the purchaser, with an obligation to replace the borrowed shares at a future date. Being short means that you’re bearish, or negative on the market, and that your goal is to make money when the price of the security or commodity that you choose to short falls in price.
Investing GlossarySimplified Employee Pension; SEP
A retirement plan available to small employers and self-employed individuals in which both the employer and employee can contribute to an IRA.
Investing GlossarySingle Premium Immediate Annuity; SPIA
An annuity contract that you purchase from an insurance company with a single upfront payment. An SPIA usually starts making regular monthly payments to you immediately.
Investing Glossarystraddle
You create a straddle when you simultaneously buy a put and a call on the same stock at the same strike price and with the same expiration date.
Investing Glossarystrangle
You build a strangle when you buy a put and a call on the same stock with the same expiration date but at strike prices that are equally out of the money. A strangle costs less than a straddle because both options are out of the money, but you only make a profit if the price of the underlying stock moves dramatically.
Investing Glossarystrike price
The price at which the stock or commodity underlying an option can be purchased (call option) or sold (put option) pursuant to the terms of the contract.
Investing Glossaryswap
An exchange of streams of payments over time according to specified terms. The most common type is an interest rate swap, in which one party agrees to pay a fixed interest rate on a notional principal amount in return for receiving an adjustable rate from another party.
Investing Glossaryteenie
One-sixteenth of a point.
Investing Glossarytick
A price change in a security’s trades. If the next trade takes a security up in price, it’s an uptick; if it takes the security down, it’s a downtick. In futures and options trading, a tick is the minimum change in price, up or down.
Investing Glossarytrading range
The spread between the high and low prices of a security or commodity within a particular period.
Investing GlossaryTreasuries
Debt obligations of the U.S. government that are secured by its full faith and credit. Treasuries include bills (maturities of less than one year), notes (maturities of 1 to 10 years), and bonds (maturities of more than 10 years).
Investing Glossaryvolatility
A statistical measure of the movement of a financial asset's price over time, gauging how fast the price of the asset changes. The price of a highly volatile security can change dramatically over a short period of time. A measure of the volatility of a security relative to the overall market is its beta.
Investing Glossarywriter
A person who is selling options. Call option writers have the obligation to sell a stipulated quantity of the underlying asset specified in the contract at the specified strike price if the option is exercised by the holder. Put option writers have the obligation to buy the specified amount at the strike price if the option is exercised.
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