Investment studies as well as my personal experience support the fact that your choice of asset allocation is the most important investment decision you can make.
There are several reasons that asset allocation does not receive as much emphasis in day-to-day discussion of mutual funds as it should. First, when picking a long-term or strategic asset allocation, I believe you should not think years but decades. This means that once this allocation is chosen, you don't need to think about changing it. Second, asset allocation is more about defense against loss than about making huge gains. This strikes investors as a bit dull. However, like in sports where defense can be an important part of offense, defending against loss is a major part of making long-term gains. Investors, who lost 50% of their investment during the bear market, learn that it takes a 100% gain to recover and 100% gains do not come easily.
The traditional view was that you might change your strategic asset allocation twice during your lifetime: once when you near retirement and once when you retire. However, I would recommend a cautious allocation even for most young investors. Investors often misjudge their willingness to take risk, and the key is to choose an allocation that you can stick with even during the toughest bear markets. Investors need to avoid falling into the trap of initially choosing a stock allocation that is too aggressive and resulting in being scared out of the stock market for good. And since we now live so long after we retire, most advisors recommend a significant stock allocation even in retirement. Thus, I am partial to choosing a strategic asset allocation that lasts for most of a lifetime. This makes sense to me since I believe an asset allocation is more a reflection of your attitude towards risk than your age.
In choosing a strategic asset allocation, simpler is probably better. A choice of 60-70% stocks and 30-40% bonds is a good basic choice. This might strike some young investors as overly cautious but I actually began my retirement account with 50% stocks and 50% fixed and this resulted in an effective learning experience and good gains. See lesson 1, 50-50 split: Where it leads and what it means .
My experience suggests that picking an allocation with which you are comfortable with and then sticking with that allocation is more important than the details of a specific allocation. It is of course fun to argue about the best specific allocation. But any allocation choice is based on the past and is trying to prepare for the future, and one doesn't really know the best allocation for the future. In fact, I get rather nervous when advisors suggest that you can expect 10% per year from stocks, if you invest for a long period of time. That has been the long term historical pattern but that might not happen in the future during a shorter period like 5-10 years.
A key decision is the number of asset classes to include in your strategic allocation. I would recommend that most investors include only US stocks, international stocks, and US bonds as part of their basic allocation. I think a good choice would be 10-15% in international stocks as part of your stock allocation.
Another key decision is how often to rebalance. Rebalancing once a year in a fairly mechanical way is probably a good choice.
The important lesson I have learned is to choose a strategic asset allocation that I can follow for years, and to stick with that allocation.
As I have grown more experienced I have been comfortable modifying my strategic allocation with a tactical asset allocation, based on more temporary conditions. Asset classes like small stocks, large stocks, growth stocks, value stocks, REITs, real estate, global bonds, and commodities are classes that can be useful as part of such a tactical asset allocation. I also view more flexible rebalancing as part of my tactical asset allocation. I will talk about tactical asset allocation in my next lesson.
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