When to buy a stock and at what price are very important decisions. However, serious investors will tell you the most important decision is how you allocate your assets. I have recently stepped back and took another look at my asset allocation with an eye toward how it will change as I approach retirement.
The first significant question you have to answer is how much do you allocate to equities and cash/fixed income. There are many approaches to answer this question, but the vast majority of investors use one of these two approaches:
I. Fixed Income % = Age
This approach by far is the most popular among conservative investors. One of its most prominent proponents is Vanguard Group’s founder Jack Bogle. It is very simple to implement. Each year year you increase your allocation to cash/fixed income one percentage point to match your age and decrease your equity allocation one percentage point.
II. Equity % = 120 – Age
Many of the more “aggressive conservative” investors choose this approach. The theory here is that equities have out-performed fixed income historically and this formula keeps you in a higher percentage of equities over your life cycle. Using this formula, you would have no fixed income allocation until you are 21 years old. It too is easy to implement; simply subtract your age from 120 and the resulting amount is the percentage that is allocated to equities with the remainder going to cash/fixed income.
For my allocation, I have chosen to implement option II. However, when I retire and begin to receive large lump sum distributions from various plans that I participate in, I will strongly consider shifting to option I.
After determining your equity/fixed income split. The next step is to decide what type of investments belong in the equity portion of your allocation. Traditional splits are based on capitalization (large/mid/small cap), origin (domestic vs. international) and sectors such as financials, healthcare, energy, etc. I chose a mixture of all the above. I look at 12 sectors as defined by Morningstar, plus real estate.
