How to divvy up your retirement money

Walter Updegrave is a senior editor with Money Magazine and is the author of "How to Retire Rich in a Totally Changed World: Why You're Not in Kansas Anymore" (Three Rivers Press 2005).

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NEW YORK (Money) -- Question: I'm 26 years old and I currently contribute 10% of my income to my retirement savings plan at work. Right now I have my money divided among four mutual funds: a large-cap fund, a mid-cap, a small-cap and an international fund. Do you think that's the proper allocation? --Danny, Tustin, Calif.

Answer: It's always hard to say what the "proper" asset allocation is for any individual. It's not just one's age that determines the right mix of assets. You've also got to take into account factors like the other investments you own, how likely you are to dip into your savings before retirement, how strong a stomach you have for market downturns - even the type of job you have.

That said, I think I've got enough to go on here so that I can give you some issues to think about so that you can arrive at a portfolio mix that makes sense for you.

The first thing I notice is that you don't say anything about bonds. So unless one or more of the portfolios you mention also owns some fixed-income investments - which doesn't seem likely - you are now devoting your entire retirement stash in equities.

Some people think that's perfectly acceptable for a youngster like you. You've got decades to go before you retire, so why not put all your money in the asset class that has generated the highest long-term returns? The fact that stocks are out of favor with many investors and thus appear to be relatively cheap compared to their pre-meltdown selling prices makes equities even more attractive.

But as compelling as that logic may be, I don't think it's a good idea for anyone to bet his or her entire future retirement security on equities.

Even though stocks do have an excellent record for delivering the loftiest returns, there's no guarantee they'll reprise that record in the future.

I'm not predicting they won't. Quite the contrary. For a number of reasons, I think stocks will likely emerge as the long-term winners again. But it's not a done deal.

The second reason I'd be wary about going with an all-stock portfolio is that even if stocks deliver an encore, the road to their superior long-term performance can get pretty bumpy. All you've got to do is look back to the Standard & Poor's 500 index's 48% decline between early 2000 and late 2002 and then the more recent 57% decline from the high of October, 2007 to the low in March of this year, and you can see just what kind of hits an all-equities portfolio can sometimes take.

So given that stocks' historic long-term gains aren't a lock in the future and that limiting yourself to stocks can lead to a white-knuckle ride, I think it always makes sense to hedge your bets by keeping at least a portion of portfolio in bonds, even at your young age.

The second thing that jumps out at me in your question is that you don't say how you've divvied up your money among the four types of funds you've mentioned. Based on the market values of all publicly traded U.S. stocks, investors as a group have put roughly 75% of their money in large-company stocks, another 15% or so in midcaps and roughly 10% in small caps. If you've spread your money equally among your four choices - and since you haven't given me a breakdown, I figure you probably have - then your portfolio is probably much more heavily weighted toward mid- and small-cap stocks than the market overall.

Assuming that's the case, it means your portfolio is even riskier than the stock market as a whole because midcaps and small-caps are generally more volatile than large stocks.

All of which is to say that I think you should re-examine your allocation and probably make a few revisions.

The first change you ought to consider is adding a broadly diversified high-quality bond fund to your portfolio. Again, I can't tell you precisely how much of your portfolio you should invest in bonds, but I'd say at least 10%, a bit more if you think you would get really skittish if your account balance takes a dive.

Next up is figuring out how to divvy up the domestic stock portion of your portfolio. As a guideline for doing that, I suggest you plug the ticker symbol for the Vanguard Total Stock Market Fund (VTSMX) into Morningstar's Instant X-ray tool.

When you do that, you'll see a Stock Style Diversification box that essentially shows how this fund (which tracks the U.S. stock market) spreads its assets among large, small and midsize stocks (not to mention growth and value). You don't have to mimic the allocations exactly, but you don't want to stray too far from them either.

Finally, you want to decide how much of your portfolio to devote to foreign stocks. If you've spread your money equally among your four funds, then you now have about 25% of your portfolio in foreign shares. That's right in the middle of the 20%-to-30% of stock holdings that I've recommended previously. So I think the percentage is about right.

But remember, you're now applying that 25% to all your assets because there are no bonds in your portfolio. So, depending on how much you invest in bonds, you might need to pare your foreign stake a bit if you don't want foreign shares to get too much beyond 25% of the value of your overall equity holdings.

Once you've got an allocation that you think might be appropriate for you, you can then see how that blend might fare in the future by plugging it into the Asset Allocator tool on the T. Rowe Price Web site.

While I think this is a good exercise for you, as well as other investors, to undergo, don't go into it thinking that you'll be able to come up with a mix that will get you the absolute highest return for whatever risk you're willing to take. No one's that good. So do the best you can, rebalance periodically and remember, you can always do some fine-tuning in the future if you don't like the way your portfolio behaves.

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