Asset allocation is the mix of stocks, bonds and cash in your portfolio. The asset allocation you select will have a large impact, as it attempts to balance risk versus reward on the long-term returns in your portfolio.
Your financial plan assumes a certain level of investment return and a certain amount of risk required to get that return. When you are investing for retirement, the goal is to build a portfolio that makes your individual financial plan work. Asset allocation helps with this goal because different assets will perform differently in various market and economic conditions.
Start with your emergency cash fund
An emergency fund is foundational to every good financial plan. Your emergency fund should be cash in an FDIC-insured account. This could be a savings account, a money market account or a short-term certificate of deposit.
Cash is an asset class, and your emergency fund is part of your personal portfolio. In the long run, cash provides the lowest return of the major asset classes, but it is also a liquid insurance policy of sorts; cash is there to cover unexpected bills or take advantage of interesting opportunities should they arise. The key is to have the right amount of cash to provide a safety net in case of financial need. Access to cash in downturns may also preclude the need to sell other assets for funding requirements. Once your cash reserve is in place, you can invest the rest of your portfolio in more productive asset classes.
The appropriate allocation of stocks and bonds
The majority of investors saving for retirement will have a significant part of their portfolios invested in stocks and bonds. Stocks have higher potential returns but come with more risk. Bonds can help diversify your investment portfolio and can be especially helpful to own in times of market volatility.
Academic studies show that having a mix of stocks and bonds can actually be less risky than bonds alone. Finding the right amount of stocks versus bonds is a balancing act. Owning more stocks means higher potential returns, which could allow you to achieve your financial goals more quickly. However, investing too heavily in stocks exposes you to the risk that a downturn in the market could set back your financial plan.
Bonds offer more stable cash flows and more predictable returns, but these returns are usually much lower than stocks. Most retirement savers who complete our financial planning process end up in a range of 50% to 80% stocks, depending on their age, income and risk tolerance. The key things to consider when selecting an asset allocation are your ability to stick with the plan in a market downturn, and the return your financial plan needs to meet your goals.
Always begin with the end in mind
The most important part of investing for retirement is having a financial plan. The financial plan is your roadmap to retirement and beyond. Investing without a plan for retirement is like leaving on vacation before you decide where you are going. As Yogi Berra once famously quipped, “You’ve got to be very careful if you don’t know where you are going, because you might not get there.” Once you have a plan, it becomes much easier to select investments that make the plan work. When you are investing for and in retirement, your portfolio is a means to an end – not the end in itself.
Investment advisory services offered through Flavin Financial Services, Inc. (FFS), a registered investment advisor. Flavin Nooney & Person, LLC and FFS are independent entities.