There are times in life when you have to make some big decisions. Where to go to college, who you’re going to marry, what house to buy . . . you know what I’m talking about! These are decisions that are going to have an impact on the rest of your life.
But sometimes we don’t put as much thought into another big decision: how to invest our hard-earned money for retirement. Having a “set it and forget it” attitude isn’t going to cut it, people! When it comes to taking the right steps to building wealth and planning for your future, deciding how you’re going to spread out your investments is right there at the top of the list.
There’s a fancy term for that in investing circles: asset allocation. Don’t worry, it’s not as complicated as it sounds! We're going to break it down for you in plain English so that you know what it is and what it means for your investment strategy.
What is asset allocation?
Asset allocation is just a fancy term for describing the way your investments are divided in your portfolio between different types of “assets,” like stocks, bonds and cash.
For example, stocks—like growth stock mutual funds—might make up 80% of your retirement portfolio while you also have 15% in bonds and the remaining 5% in cash investments. That means your asset allocation is 80% stocks, 15% bonds and 5% cash.
Makes sense, right? The trick is getting your asset allocation right. We’ll get to that in a minute.
Why does asset allocation matter?
Deciding where to send your money is one of the most important investment decisions that you’ll make. Why? Because your asset allocation—the way your investment portfolio is split up—will play a huge role in determining what kind of returns you should expect from your investments over the long haul.
If you want to reach your retirement goals, you need to get your asset allocation right. It’s a huge deal!
What are some different types of asset allocation?
The idea behind asset allocation is to balance risk and reward by dividing up your portfolio’s assets based on your financial goals, how much risk you’re comfortable taking on, and the total amount of time you expect to hold onto your portfolio.
Based on those factors, there are basically four different types of asset allocation you need to know about:
1. Conservative Asset Allocation
This approach is designed for investors who are afraid of the stock market and want to minimize their risk. They wouldn’t go skydiving with you if you paid them to. Most of your investments in a conservative form of asset allocation will be in bonds and cash, while only a small percentage will be used to buy stocks.
This is not a winning approach for saving for retirement. The average annual returns for bonds hover around 5%, and cash investments—think certificates of deposit (CDs) and money market accounts—average less than a 1% rate of return.1,2 Don’t settle for wimpy returns from bonds and cash investments—you can do much better!
2. Moderate Asset Allocation
This is for folks who have a slightly higher tolerance for risk, but the idea of the stock market going up and down still makes them feel queasy. One example of a “moderate” approach is to have around one-third of your investments in stocks and the rest in bonds and cash.
Is this type of approach going to cut it? Nope! The returns you’ll get from bonds and cash investments simply aren’t enough to keep up with inflation, which cuts into your purchasing power by 2–3% each year.3
3. Balanced Asset Allocation
This is the “yin and yang” approach to asset allocation, where half of your investments are in stocks and the other half is in bonds and cash.
Market chaos, inflation, your future—work with a pro to navigate this stuff.
The problem with a “balanced” asset allocation is that the values of stocks and bonds often don’t move together—in fact it’s usually the opposite. When stock prices start to rise, bonds usually start going the other direction, and vice versa. Having an even mix of bonds and stocks in your portfolio is like having two people in the same boat rowing in opposite directions—you’ll end up going nowhere fast!
4. Growth Asset Allocation
That brings us to the last type of asset allocation: growth asset allocation. When you use a growth approach to asset allocation, that means you understand the risks of the stock market and most (or all) of your investment portfolio is made up of stocks. Will you experience some highs and lows investing in stocks over the years? Absolutely. But you have to remember that the stock market historically has an average annual rate of return between 10–12%.4
This is the mindset we want you to take with asset allocation. You want to think growth. Saving for retirement is a marathon, not a sprint. This is not some “get-rich-quick” scenario—you’re in this for the long haul. If you stick with it and don’t jump off at the first sign of trouble, you’ll give yourself a chance to have the retirement you’ve always dreamed of.
What is the best approach to asset allocation?
When it comes to investing, there’s always going to be some risk involved. You can’t avoid it! The key is to manage those risks through diversifying your portfolio the right way.
That’s why we want you to invest solely in good growth stock mutual funds, which allow you to diversify your investments by letting you buy pieces of stock from many different companies.
Here are a couple reasons we like mutual funds so much. First of all, stocks historically have much better returns than bonds—which means more money in your nest egg over the long haul. If you start shifting to bonds and cash as time goes on, you risk falling behind and potentially having hundreds of thousands of dollars less in your nest egg by the time you retire.
And second, by investing in growth stock mutual funds, you’re naturally diversifying your retirement savings so that your portfolio isn’t dependent on single stocks and the fortunes of individual companies (that’s a bad plan).
You can spread out your investments and reduce your risk by investing evenly across four different types of growth stock mutual funds:
- Growth and income funds: These are the most predictable funds in terms of their market performance.
- Growth funds: These are fairly stable funds in growing companies. Risk and reward are moderate.
- Aggressive growth funds: These are the wild-child funds. You’re never sure what they’re going to do, which makes them high-risk, high-return funds.
- International funds: These are funds from companies around the world and outside of your home country.
Having those types of funds in your portfolio adds another level of diversity to your investing, which lowers your risk while still letting you reap the rewards of investing in growth stocks. That’s a win-win for you!
Get With a SmartVestor Pro Today!
Now, the next step is finding the right mutual funds to invest in. Don’t worry, you don’t have to do that alone! Wherever you are in your financial journey, we encourage you to sit down with an investment professional who can walk you through the process.
That’s where our SmartVestor program comes in. It’s a free service that connects you with investment professionals in your area. Each one has been vetted by our team at Ramsey Solutions, and they will patiently walk you through the investing process and help you spread out your investments the right way.
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This article provides general guidelines about investing topics. Your situation may be unique. If you have questions, connect with a SmartVestor Pro. Ramsey Solutions is a paid, non-client promoter of participating Pros.