What Is The Best Portfolio Allocation? Designing a portfolio that delivers strong returns within a desired timeframe requires careful planning. The plan must consider how to minimize taxes and fees, which assets to include, and how to balance risk against potential reward.
The first step in the planning process is to ask important questions:
What are your financial goals? For example, are you saving for a major purchase, or are you building wealth to see you through your retirement?
What is your investment horizon? Is there a timeframe in which you want to meet your financial goals?
How much time can you realistically devote to investment-related research?
Assuming you have the time, are you genuinely interested in doing in-depth research on potential investments?
How comfortable are you with taking financial risks? In other words, where would you place yourself on a risk tolerance scale?
Can you remain disciplined and stick to your strategy through periods of market volatility, or is it likely that economic ups and downs will influence your investment decisions?
There are no right or wrong answers to any of these questions, and your responses don’t make you a “good” or “bad” investor. They simply provide insight into your priorities and goals, so you can design a successful investment strategy that meets your individual needs.
What Is Portfolio Allocation?
Once you have a clear understanding of your investment goals and the personal characteristics that will play a part in building and managing your portfolio, the next step is to determine how to allocate your portfolio.
In simple terms, portfolio allocation is the percentage of your portfolio that is dedicated to a particular asset class.
The most common asset classes include equities (e.g., stocks and related products like stock options, mutual funds, and exchange-traded funds – ETFs), bonds, and cash or cash equivalents.
There are a variety of other asset classes, such as commodities, real estate, venture capital, and so forth, but these are less common in a basic portfolio.
Equities are generally considered higher risk than bonds and cash, but overall, they deliver better returns than other assets. While there is an increased risk that equities will lose value compared to bonds and cash, the higher returns offer protection against inflation.
Cash sitting in a savings account might be safe from market volatility, but its purchasing power decreases as the cost of goods and services increases over time. Bonds typically pay more interest than traditional savings accounts, but they cannot be counted upon to keep up with inflation.
A healthy balance between asset classes through thoughtful portfolio allocation is the only way to stay ahead of inflation without taking on excessive risk – but what is the best portfolio allocation?
What Is The 60/40 Portfolio?
Historically, the market has had its ups and downs, but it has always recovered and gone on to reach new heights.
Over the past 100 years, stocks have collectively generated almost twice the returns of bonds. The trouble is those pesky ups and downs – particularly the downs. If your investment horizon is comparatively short – under ten years or so – there is a risk that your portfolio will lose value at the same time you need those funds.
A 60/40 portfolio refers to a standard portfolio allocation of 60 percent equities and 40 percent bonds. When you are getting close to your distribution date, this allocation reduces volatility – but of course, the advantage of increased stability comes with the disadvantage of lower returns.
What Is The 70/30 Portfolio?
If you have a long investment horizon – for example, growing your wealth to fund your retirement – you can afford to ride out market cycles.
A 70/30 portfolio puts a larger portion of your assets in equities, which gives you the benefit of higher returns. Your balance will drop during bear markets, but you can afford to wait until it recovers when you have many years of building wealth ahead of you.
Investors who lack the time and interest necessary to research investments and maintain their portfolios may wish to consider one or more funds that automatically manage portfolio allocations based on a target distribution date.
For example, Vanguard has a family of funds designed for retirement savings. Based on the expected date of retirement, funds gradually shift allocations from higher-risk equities to more reliable bonds so that the funds are available when needed.
Some of Vanguard’s target date funds include:
Vanguard Target Retirement 2025 Fund – Stock 55.86 percent/Bond 42.97 percent
Vanguard Target Retirement 2035 Fund – Stock 71.34 percent/Bond 27.42 percent
Vanguard Target Retirement 2045 Fund – Stock 85.98 percent/Bond 12.71 percent
Vanguard Target Retirement 2055 Fund – Stock 89.13 percent/Bond 9.63 percent
Vanguard Target Retirement 2065 Fund – Stock 89.24 percent/Bond 9.41 percent
Investors with more time before retirement can choose stock-heavy funds, while those who plan to retire sooner can choose more stable funds that include a higher percentage of bonds.
If you have the time and interest to research investment opportunities and examine the fundamentals of every stock you intend to purchase, you can pass on target-dated funds in favor of individual trades.
However, portfolio allocation doesn’t end with choosing the right balance of assets. Optimizing returns and reducing risk requires a deliberate plan for diversification.
How To Build A Diversified Portfolio
Portfolio allocation between asset classes reduces volatility caused by changing economic conditions that impact the market as a whole. However, it is common for certain sectors of the economy to experience challenges while other sectors are thriving. It is also possible for individual companies to lose value, though others in the same industry are growing.
Diversification protects your portfolio against extreme losses by spreading risk across multiple sectors, industries, and types of companies.
For example, instead of exclusively holding high-growth tech stocks like Apple, Netflix, and Meta, a well-diversified portfolio would include a mix of tech stocks and stocks in other sectors – perhaps healthcare, energy, consumer discretionary, and consumer staples.
There is no need to own stocks in every industry, but it is important to select those that complement each other – when one goes down, the other tends to remain steady or go up.
At the moment, tech stocks as a whole are down, and energy is up. A portfolio with both tech and energy stocks enjoys relative stability, while one almost entirely made up of tech stocks has likely lost a substantial portion of its value.
Other considerations for diversification include company size, geography, dividend, growth, value, and so forth. Mixing high-quality stocks across geographies, company size, and similar increases the stability of your portfolio. For example, adding stocks from emerging economies like Brazil’s Nu Holdings in addition to domestic fintechs like Robinhood ensures you enjoy the best of both worlds.
There is no hard rule when it comes to how many stocks to hold, but most investment advisors recommend around 25 to start. If that isn’t practical, you may wish to consider an ETF. These low-fee funds offer instant diversification in every share because they track an underlying index like the S&P 500.
What Is The Best Portfolio Allocation? The Bottom Line
The bottom line is that there is no “best” portfolio allocation because this is an area where one size doesn’t fit all.
The appropriate ratio of stocks to bonds, the addition of less common asset classes like real estate and commodities, and the type and mix of equities and related products depend on highly personal factors that vary from investor to investor.
As you build your portfolio, consider best practices in terms of how much to invest in equities versus bonds and which stocks to buy – but ultimately, the final decision comes down to your level of comfort with various strategies and your unique financial objectives.
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