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Finding the right mix
Your goals, risk tolerance and time horizon are the key.
The ultimate financial goal, of course, is retirement. How soon you retire -- and in what style -- can be greatly affected by your decisions on asset allocation earlier in life. In accounting for risk in your asset allocation, it's more productive to think in terms of your tolerance for volatility. This is because one of the greatest investment risks is the risk of doing nothing -- and missing out on superior returns.
An individual planning to retire in 15 years who has a high tolerance for volatility may want to have 70 percent of his or her holdings in the stock market, 28 percent in bonds, and 2 percent in money markets. If this person is planning to retire in 25 years, he or she might ratchet the securities holdings up to 80 percent.
Those retiring in 15 years but with less stomach for volatility may want to keep 50 percent in stocks and 38 percent in bonds. For equally volatility-shy people 10 years younger, the percentage in stocks could be around 65 percent.
Those retiring in five years are faced with the daunting task of allocating their assets for maximum return without betting the farm. A nasty market dip could occur immediately before retirement, leaving the retirement kitty drastically short.
Individuals this close to retirement who can live with higher volatility may want to put all of their holdings in stocks, weighted mainly in large-cap issues that are more dependable in the medium term than smaller caps and internationals. Those who can't take as much heat may want to put as much as 48 percent in bonds (principally intermediate-term bonds), 2 percent in money markets and 50 percent in stocks -- again, primarily large-cap stocks.
If your investment goal is putting your kids through college -- that is, if you're using a separate pool of funds for this with a separate asset-allocation plan -- you may want to consider putting a bit more in the stock market. For example, those with high volatility tolerance might put 80 percent in stocks, while those who sleep more fitfully might limit their securities investments to 65 percent or even less.
Achieving the right mix of stock types (small-, mid-, and large-caps and internationals) and bonds (short, medium and long-term) to achieve maximum return for your volatility tolerance while maintaining adequate diversification is a tricky business, so you may want to consider consulting a qualified financial planner or adviser.
Before you actually invest in accordance with your newly minted allocation plan, you will want to do something that few individual investors do: Find out specifically what you own. Most people don't know precisely what they own because their portfolios are dominated by an accumulation of mutual funds. If you strip away the marketing veneer of each fund and do some investigating, you can not only find out what the fund says it's comprised of, but what it actually is.
For example, some funds may call themselves small-cap. But, given the less-than-stellar performance of small-cap stocks over the past year, these same funds may have veered into large-cap territory to boost their returns. Your fund's 800-number reps should be able to give you information on this. If they won't or say they can't, find another fund.
The need to determine what you already own is another reason to hire a qualified financial advisor; he or she would have a good handle on most funds. As your advisor would tell you, you must break these funds into their component parts to know what percentage of your assets is in small caps versus large, or in long-term bonds versus short-term. Without this awareness, you could, for example, labor under the assumption that your stocks are diversified across companies by size, when, in fact, every dime you have in securities is in large caps.
Moreover, you should know what types of stocks your fund is buying by sector. If your fund is tech-heavy, that's okay, as long as you don't have too much in this fund and are sufficiently diversified with stocks from more traditional manufacturing concerns, which tend to rise when techs fall.
Similarly, don't take your short-term bond fund's word that its holdings are all short-term. Find out what they think is short-term, mid-term and long-term, and determine what they actually own. Moreover, check out their credit criteria. Are they strictly into top drawer AAA's? Or are they dabbling far lower on the pecking order by exploring newly popular junk bonds?
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