Check Your Asset Allocations

Saving Money Tip #110- Check Your Asset Allocations. In yesterday’s post, I mentioned risk allocation, but did not fully explain what it is. When you have money saved up, it is usually in various places – savings accounts, checking accounts, stocks, bonds, CDs, and mutual funds. Each of these has a risk associated with it. A savings account is considered to have low or no risk. A stock mutual fund is generally considered high risk (although there is a wide range of risk among the hundreds of stock mutual funds out there). Bonds may be considered medium risk or low risk, depending on the type. In general, people will undertake more risk for hopes of a greater return, while they will accept less of a return in exchange for lower risk.

When you start putting money away for savings – whether it be for retirement in the long-term, for college in an intermediate term, or for a car in the short-term, you will have to decide where to put the money – accounting for the amount of risk that is appropriate for your time horizon and what you are comfortable with. In general, the shorter time horizon you have, the least risk you should undertake. The longer the time horizon, the greater the risk. This is because historically, riskier investments such as stocks are volatile, but over the long-term they tend to go up.

There are general “rules of thumb” about how you should allocate your assets, based on time horizon, but again, you have to do what you are comfortable with. So, let’s look at a simplified example of what asset allocation or risk allocation is. Let’s discuss a hypothetical retirement portfolio. Suppose Mary who is 30 years old has $30,000 saved so far for retirement. Half of it is in stock mutual funds ($15,000), while the other half is in government bonds ($15,000). Her current asset allocation is 50% high risk and 50% low risk. She plans to save an additional $15,000 this year to add to her retirement account.

Mary has recently spoken with a financial advisor who has explained that because she has more than 30 years until retirement that she can afford to take on more risk. Mary is comfortable with that and wants to change her asset allocation from 50% low risk/50% high risk to 30% low risk and 70% high risk. In order to do that, she is going to put all of her new savings of $15,000 at the beginning of the year into stock mutual funds. She will then have $15,000 in low-risk bonds and $30,000 in high-risk stock mutual funds. Her new asset allocation is 33% low risk and 66% high risk. It is not quite at her goal of 30% low risk and 70% high risk, but it’s closer than where she was. Mary decides to keep the current investments where they are and make the change to the 30/70 asset allocation gradually over the following year as well.

At the end of the year, Mary checks her balances on her account to her risk allocation proportions. She finds that the balance on her bonds is $16,000 and the balance in her stock mutual funds is $24,000 because the stock market performed poorly this past year. Her new asset allocation is 40% low risk and 60% high risk. She still wants a 30%/70% allocation in her retirement account. In the upcoming new year she plans to put $12,000 toward retirement. She puts all of it into stock mutual funds making her balance $36,000 in stocks and $16,000 in bonds. Her asset allocation is now very close to the 30% low risk/70% high risk that she wants.

At the end of the year, she will evaluate the balance in each of her accounts again, influencing how she will invest the new retirement money to keep her 30/70 asset allocation. As she ages, she may want to change her asset allocation to 40% low risk/60% high risk then to 50/50 all the way up to 100% low risk/0% high risk when she is only a few years away from retirement. So she will monitor her funds yearly and make any necessary changes to keep the asset allocation the way she wants it.

In Real Life (IRL) – First I will say that I am more conservative than what financial advisors advise. I am about 20 years away from retirement and most experts would suggest that I still have 60 percent of my retirement portfolio in stocks. We have less than that in high-risk investments – with 45% in stocks and 55% in lower-risk investments, although some of those low risk are not no-risk investments – many are more intermediate risk. Regardless, for our age we took on the amount of risk that we felt comfortable with for our retirement portfolio. We will probably keep this asset allocation for the next 5-10 years and then lower the percentage in stocks even more. At the end of each year, I evaluate the asset allocation and then I decide where we will invest next year’s retirement money – in stocks, bonds, CDs, etc. to keep the mix the way we want it.

Our other big savings is for college education. And I’m afraid we’ve been pretty conservative here, too. My oldest daughter is 11 years away from college and only 20% of her savings are in high-risk investments. The rest are in CDs. With what the stock market did this past year, I am glad that we invested conservatively, but only time will tell over the next 11 years whether we should have kept a more aggressive asset allocation.

Regardless of whether you are a conservative investor or a high-risk investor, you need to decide what you want your asset allocation to be for each of your investments and then evaluate it once a year and adjust it accordingly to keep the mix the way you want it.