There’s this phrase called “asset allocation,” and every time I say it, I see people’s eyes glaze over. Asset allocation? Yawn. Sounds boring.
So let me put this a different way: you can become filthy rich by dividing your money in the right way.
And knowing “the right way” isn’t a matter of rocket science … it’s actually very basic. By the end of this post, you’ll know it.
Step 1: Divide Based on Your Age and Risk Tolerance
First, start by deciding how much of your cash 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 more 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’s not going to earn you more money. 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.
Foreign funds are divided into two categories: Developed Markets (Europe, Canada) and Emerging Markets (Brazil, China, India).
Domestic funds are divided into three categories: Large-Cap (big companies), Mid-cap (medium companies), and Small-Cap (obviously, small).
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
Unless you’re trying to time the bond market (stay tuned: more on how to do that later), bond funds are even easier than stock funds: they come in varieties of short-term, mid-length and long-term.
If you want to withdraw the money within 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).
If you want to withdraw the money within 5-10 years: put that piece of the pie into an intermediate-term bond index fund.
If you want to withdraw the money within 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 and “safe” bonds (different risk levels), and there’s lots of chatter about the interest-rate risk that bonds carry. Stay tuned for a future post on these topics.
But remember: 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.