NEW YORK (CNN/Money) - The stock market has become a minefield. Off in one direction, telecoms barely have a pulse. Look the other way and the Dow is struggling to stay above 10,000. Add Enronitis and earnings warnings to the mix and investing is as dangerous as hand-to-hand combat.
How can you protect yourself? You do have a powerful weapon in your arsenal that can shield you from the most lethal bear market -- an asset allocation plan. Simply put, it's when you invest your money in different types of stocks and bonds to spread your risk. There's nothing that will safeguard your money better, short of stuffing it under the mattress.
Here is a three-step plan to figuring out the best asset allocation for your situation.
Step one: Do a self-assessment
First, you need to figure out when you need the money. Are you planning for retirement? Saving for junior's college education? Or maybe you want to have enough for your dream house 10 years down the line. Sit down and put your dreams on paper. While you're at it, figure out how much they will cost.
Three steps to asset allocation
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|||Know when to shift your mix
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The more time you have in the market, the riskier you can be. The sooner you need the money, the more you will have to hedge your bets with bonds or even cash (highly liquid money market accounts.)
"You build an asset allocation plan based on what makes sense for you -- no matter what the economy and the market are doing," said Mary McCarthy, an investment counselor at Strong Advisor.
The next step in your self-assessment is more complicated -- where you need to figure out your risk tolerance. There are lots of ways to do it. Many investing pros use a sleep analogy: Are you up nights worrying when the market is down?
Part of your risk level will also depend on how much money you have. If you make a six-figure salary, maybe you can push the envelope a little. But if you're on a tight budget and you have one small nest egg for retirement, you need to be more cautious.
Another way to figure out how much volatility you can take is to look at historical market performance. If you invested 100 percent of your money in stocks between 1926 and 2000, you would have earned average annual returns of 11 percent, according to Vanguard. Your worst one-year loss would have been 43.1 percent.
At the other extreme, a tame portfolio of 80 percent bonds, 10 percent stocks and 10 percent cash would lessen the blow in the worst year (a loss of just 6.7 percent) but your gains would be tamer, too: average annual returns of just 6.2 percent. Could you take a 43 percent loss in a single year? Or, put another way, could you live with modest gains of less than 7 percent a year?
Step two: Pick your mix
So now you've figured out where you fit in the spectrum. How do you divvy up the money? If you're young and starting out investing, there's no reason why you shouldn't put all of your money in stocks, said Judith Ward, a certified financial planner at T. Rowe Price's advisory services. Even someone in his 30s might stick with an all-stock strategy.
A moderate investor with 6 to 10 years:
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If you're not comfortable with that, T. Rowe Price has a range of suggested portfolios with higher, medium and lower risk depending on whether you're investing for five years or less; six to 10 years; or 11 or more years. For example, let's say you're saving for a house in five years. You consider yourself pretty risk-tolerant. The recommended mix is 60 percent stocks, 30 percent bonds and 10 percent cash.
Or, if you're more moderate and saving for retirement in two decades: You'd pick 80 percent stocks and 20 percent bonds, according to T. Rowe Price. A low-risk investor saving for six to ten years would pick 40 percent stocks, 40 percent bonds and 20 percent cash.
"The hardest thing for investors to understand is the potential risk of the portfolio they're in," Ward said.
A low-risk investor with less than five years:
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Within your stocks allotment, divide the money between large-, mid- and small-cap stocks, including both growth stocks, which have rapidly growing earnings, and value stocks, which are the underdogs of Wall Street. And don't forget some international exposure -- the amount can vary from 10 to 20 percent.
Pat Jennerjohn, a certified financial planner from California, recommends a stock lineup of 50 percent large caps, 15 percent mid-cap stocks, 20 percent small-caps and 15 percent international stocks.
Step three: Know when to shift your mix
Having a solid asset allocation plan will take you through up and down markets, but it doesn't stop there.
You'll also have to rebalance your mix through the years. That means you need to look at your allocation and make sure it doesn't get out of whack because of what's happening in the market.
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For example, in recent years, value stocks have done much better than growth stocks. Let's say you started out with your portfolio split equally between large growth and large value stocks three years ago. Today, because value stocks have done so much better, you might find you now have 54 percent value and 46 percent growth.
Over time, the numbers will get even more out of kilter unless you rebalance, by selling off some value and buying more growth. Take a look at your allocation once a year, and rebalance when the numbers change by more than five percentage points.
And as soon as you hit a big milestone in life -- you get married, have a child, get divorced or have a serious illness -- you want to take another crack at asset allocation. You may decide you're less risky if you become a single parent, or you may decide you're willing to turn up the heat on your investments.