Step 2: Divvy up your assets
The term "asset allocation" is enough to strike fear (or provoke boredom) among many investors. But that's because they may be thinking about asset allocation all wrong.
Consider it a dating game between your goals and your money. Match a goal to the right type of investment and the couple will live happily ever after. And, of course, so will you, because you'll have the money you need, when you need it, to finance the things that are precious to you. Let's take this matchup step-by-step.
- Dream the dream: What do you want? A house? A car? Annual vacations in exotic locales? Or just enough money to handle emergencies and send your kids to college, and time to spend with your grandkids when you're older? Make a list and put it in the order of what's most important to you.
- Make a timeline: Put an expected date of arrival next to each goal. For instance, the need for your emergency fund is immediate, but your teen's college money won't be needed for, say, four or five years. When will you start tapping your retirement money? How long do you expect to need it in retirement?
- Estimate the costs: Some goals are easy to put a price tag on -- the price of a new car, for example, or an emergency fund big enough to cover about six months of your living expenses. Other long-term goals, such as college for the kids and a comfortable retirement, are trickier to quantify. The good news is that the numbers don't have to be precise. Just getting in the ballpark will help.
For college, go with your best guess, given your child's wishes and prospects and what you're willing to pay. Two-year community colleges charge about $2,900 a year. The current average annual cost to attend a public university is $17,131, and that rises to $38,589 for a private school.
Now, you wouldn't try to fix up two friends who had nothing in common with each other. You likewise can't match your goals to the right assets without knowing a little about them. Here are the basic characteristics of different asset classes:
- Cash investments. Money in bank accounts, money market funds and short-term Treasurieys and certificates of deposit are all about safety. They don't pay much, but they're there when you need them. They're ideal for emergency money and short-term goals.
- Income investments. Longer-term certificates of deposit and corporate and government bonds can serve two purposes. They can provide regular income while earning a higher return than cash investments, or they can be matched to mature at the same time as you anticipate needing the money. For instance, buying a high-quality bond that matures the same year your child goes to college gives you a fairly high degree of certainty about how much you'll have to address that goal.
- Growth investments. U.S. and foreign stocks are ideal for long-term goals because, while subject to violent short-term swings in value, they usually return much more than the inflation rate over time. That makes them a great match for your retirement savings plan.
- Inflation investments. Commodities and Treasury inflation-protected securities are worth owning to guard against the ravages of inflation. Putting 5% to 10% of your money in TIPS and commodities should provide insurance against runaway prices.
Now, match them up. Take the money you determined that you'd need when you estimated the costs for each goal, and match it with the right asset. For emergency money, pick among the cash investments; for medium-term goals, choose among the income investments; for long-term goals, feed your monthly savings into a variety of growth investments and inflation hedges. That diversity helps stabilize your overall nest egg, because some investments will increase in value as others fall.
Also realize that as you get closer to long-term goals, such as retirement, a portion of your savings will slide into the "medium-term goal" category. Start shifting a portion of those assets into income-oriented investments about 10 years ahead of the goal.
Step 3: Make regular adjustments
Now that you're an asset-allocation whiz, you'll occasionally need to "rebalance" your portfolio to keep the proportions where you want them. That's because various investments increase and decrease at different speeds and at different times. And, of course, your goals could change from year to year, too.
Figure on spending one hour each year reviewing your goals and adjusting your asset mix when market conditions or life events throw the portfolio out of whack. Say, for instance, you decided that you need to have 25% of your assets in bonds and 75% in stocks. Then bonds go crazy while stocks wilt, and you find yourself with 35% in bonds and 65% in stocks. In that case, sell enough of your bonds and buy enough stocks to restore the right mix. Or, if you're investing regularly, you can rebalance by simply directing new investments into stocks rather than bonds until you reach the proper balance.
If you have a very large portfolio and are an active investor, it might make sense to rebalance more frequently -- say, once a quarter or once every six months. However, if you have to sell assets to rebalance and your money is in a taxable account, you may get stuck with a tax bill. So don't overdo it. Better yet, do the bulk of your rebalancing in tax-deferred accounts, such as IRAs.
More from Kiplinger's Personal Finance magazine:
VIDEO ON MSN MONEY
You only need two steps.
1. Buy (15% of your income invested into the stock market averages).
Suppose you're preparing for retirement by saving $10,000 a year over the next three decades. Assuming your portfolio averages an 8% annual return before fees, you would retire with a nest egg of a bit more than $1 million if your costs totaled 1% a year. This nothing but a wild dream unless up are lucky in the Stock Market. Try saving money in a money market account or CD and watch it go down a rat hole because of inflation. ♥♥
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