Retirement Investing: Tips for Creating the Proper Asset Allocation

No matter what retirement savings vehicle you're using – 401(k), Roth IRA, Traditional IRA, or some combination of the three – once you find the money to stash away, you can easily set up automatic contributions each month. By doing so, the money is whisked out of your bank account before you ever have a chance to spend it. But that doesn't mean your role in the retirement savings game is over.You will also need to determine how you want to invest that money. Within each plan, there are a range of investment options (in general, IRAs have significantly more options than a 401(k)) that you'll need to choose among. But first, you'll need to weigh a few factors about yourself – including your age, your risk tolerance, and when you plan to retire – and then figure out how you are going to spread your money across the different investment categories. This is called an asset allocation.

Figuring Out the Right Asset Allocation for You

You've no doubt heard the advice that you should not put all your eggs in one basket. That is exactly what an asset allocation aims to avoid. If you throw all of your money into stocks, and the stock market takes a dive, you're toast. Same goes with bonds and cash. A typical asset allocation includes various stocks, or equities, for long-term growth, bonds for income and security, and cash for short-term needs. How much you hold of each category is up to you, but there are a few rules of thumb to follow:
  • Take risk early on. The younger you are, the more risk you can take because your portfolio has more time to bounce back if it hits a bump. Stocks are the riskiest investment, but they also have the greatest return. Money you don't need to touch for a long time – 10 years or so – belongs in stocks. Round out your portfolio with bonds, which provide a smaller return in exchange for less risk, and cash investments, like money market funds and CDs. How much you should have of each is a personal decision, but – as an example – the typical 40 year old might have 60% in stocks, 30% in bonds, and 10% in fixed-income, or cash.
  • Buy buckets. Instead of picking and choosing individual stocks – a heavy undertaking, and risky for the novice investor – buy index funds or exchange-traded funds. These allow you to buy a piece of multiple investments, a much more diversified risk because if one company falters, the others will (hopefully) even things out. "Look for a vehicle that will gives you more numbers than less – in other words, how many underlying securities are in that fund? You can buy a mutual fund with as little as 40 companies represented, or one with 1500. The more companies represented, the better diversified you are," says Cathy Pareto, a fee-only financial planner in Coral Gables, Fla.
  • Think globally. "This is starting to change as people realize we're living in a global world, but a lot of people still tend to overweight their own country. They focus on U.S. investments considerably, versus international or even emerging markets," says Pareto. You don't have to be familiar with companies in other countries – you can purchase an international index fund to cover your bases.
  • Stay on top of it. You can't, unfortunately, set it and forget it. The market moves, and your allocation can get out of whack. You'll also age – I'm sorry, it's unavoidable – and your risk tolerance may change. So about once a year, look at where you stand and see if you're still comfortable.
  • Finally, don't be afraid to get help. There are financial planners out there who will work with you on an hourly basis, if that's all you can afford, just to help you check on things. You can find one near you through the Garrett Planning Network. A pair of expert eyes is very often worth the money.

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johnbankheadd

Could you explain to me how does the compounding take effect? I've had a roth for a year now.

October 24 2010 at 9:18 AM Report abuse rate up rate down Reply