When you are setting up your own asset allocation scheme, there are two primary things that have to be considered. First, you must decide how to allocate your funds among different classes of assets in order to maximize profits and minimize the risk of loss. Second, you should try to maintain the proportions of the allocation so as to keep your investment portfolio well diversified. The key to proper asset allocation is diversification.
Age Based Method
One simple guide to determine how much of your money to have in stocks is to use your age as a guide. Subtract your age from 100. This is the percent of your portfolio that should be in stocks. A 20 year old can safely have up to 80% of his or her money in stocks, while a 75 year old would only want about 25% in the stock market. Cash and money markets should make up the remainder of the investment portfolio. As you get older, less and less of your investments should be in higher risk securities.
Although this is a good starting point to set up your own asset allocation, it often ends up over-simplifying the situation. A 45 year old with a couple of children an average income cannot be compared to a 45 year old who is single and makes a higher income. The 100 minus your age rule does not apply to everyone – rather it serves as a rough guide. Also, this “rule” does not tell an investor how to diversify their stock portfolio in to different sectors of the economy.
Using broad based mutual funds or ETFs.
As mentioned above, getting the right mix of stock to cash investment is important, but you also must diversify what stocks you own. One easy way to do this is to buy mutual funds. These are investments that invest in a wide range of individual stocks. They free you from having pick stocks one by one.
The best mutual funds are “no-load” funds with low expenditures. They aim to reproduce the broad stock market. For example, the Vanguard S&P500 fund has no start up fees (loads), is cheap to operate, and owns shares in the 500 stocks that make up the S&P500 index. It provides instant diversification in the stock market. You can also achieve the same goal when you invest in ETFs – Exchange Traded Funds. These are mutual funds that are traded on the regular stock exchange and are becoming quite popular as of late.
Setting up your own asset allocation is not that hard, if you do some basic research. You have to decide how much risk you are willing to take. Then divide your portfolio in to different investments. As the values of those investments change, you can make adjustments as needed. In essence, this is just a way of being properly diversified.