There’s this phrase called “asset allocation.”
Every time I say it, people’s eyes glaze over. Yawn. Sounds boring.
So let me put this a different way: you can become filthy rich by dividing your money in the right way.
Knowing “the right way” isn’t rocket science … it’s basic. By the end of this post, you’ll know it.
Step 1: Divide Based on Your Age and Risk Tolerance
First, stash 3 months of your basic expenses into an emergency fund. This is NOT an investment. It’s for emergencies only.
Got it? Good.
Okay, now decide how much of your investment money to divide between:
- Stocks (mutual funds, index funds, ETFs)
- Fixed-income investments, like bonds
- Cash and other liquid assets (money market accounts, CDs)
Stocks are volatile. In the short-term, they carry more risk. In the long-run, they make higher returns.
Cash is — well, cash. It’s safe, but it’ll barely keep pace with inflation.
Fixed-income, like bonds, is the happy medium between the two.
How do you decide based on age and appetite for risk? This simple rule of thumb will tell you.
Step 2: Divide your Stock Funds Among These Major Categories
Stock funds – like index funds and ETFs – fall under two major categories: Foreign and Domestic.
Domestic funds are divided into three categories: Large-Cap (big companies), Mid-cap (medium companies), and Small-Cap (obviously, small).
Foreign funds are divided into two categories: Developed Markets (Europe, Canada) and Emerging Markets (Brazil, China, India).
If you love risk:
Then follow this formula for your stock funds (index funds and ETFs):
40% domestic large-cap markets
20 % domestic mid-cap and small-cap markets
30% in foreign developed markets
10% in foreign emerging markets
If your risk appetite is only so-so:
Then follow this formula for your stock funds:
50% domestic large-cap funds
30% domestic mid-cap and small-cap funds
10% foreign developed markets
10 % foreign emerging markets
If risk makes your stomach queasy:
Then follow this formula:
60% domestic large-cap funds
15% domestic mid-cap funds
10% domestic small-cap funds
10% foreign developed markets
5% foreign emerging markets
How do you know your risk tolerance? Take this quiz.
Step 3: Invest your fixed-income funds based on withdrawal time
Bond funds come in three varieties:
Make your choices based on when you want to withdraw your cash.
- 1-5 years: invest the fixed-income portion of your portfolio in a short-term bond index fund. (Remember, in Step 1 you decided what portion of your portfolio would go into fixed-income funds).
- 5-10 years: put that piece of the pie into an intermediate-term bond index fund.
- 10-15+ years: stick it in a long-term bond index fund.
I’m simplifying bonds here, because they do get more complex: there are “junk” bonds, “safe” bonds and floating-rate notes. There’s interest-rate risk and coupon payments. It can get as complex as you want it.
But remember: Simple is best, and perfect is the enemy of good.
The longer your cash is sitting in a checking account, the more gains you’re missing. So keep it simple, don’t over-think it, and slice up your portfolio based on this simple, 3-step formula.