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Investing Specialists

Find the Right Stock/Bond Mix

Asset allocation is the biggest determinant of how your portfolio behaves.

Note: This article is part of Morningstar's November 2013 Investor Starter Kit special report. An earlier version of this article appeared April 19, 2013.

Are you a stock or bond?

You may not be accustomed to comparing yourself to a financial security, but it may be useful when you're trying to figure out your portfolio's optimal stock/bond mix.

The thinking goes like this: If your own earnings power--which Morningstar company Ibbotson Associates calls "human capital"--is very stable and predictable, then you're like a bond. Think of a tenured college professor, whose income is secure for the rest of his life, or a senior who's drawing upon a pension from a financially stable company. Because such an individual has a predictable income, he could keep a larger share of his portfolio in stocks than someone with less stable human capital. He's a bond.

At the opposite end of the spectrum would be an investment broker whose income depends completely upon the stock market. When the market is going up and the broker's clients are clamoring to invest, her commissions are high and she may also earn a bonus. But when the market is down, so is her income, and her bonus may be nonexistent. She's a stock. She'd want to hold much more in bonds than stocks, because her earnings are so dependent on the stock market.

Just as our career paths affect how we view our own human capital, so do our ages. When you're young and in the accumulation phase, you're long on human capital and short on financial capital--meaning that you have many working years ahead of you but you haven't yet amassed much in financial assets. Because you can expect a steady income stream from work, you can afford to take more risk by holding equities. As you approach retirement, however, you need to find ways to supplant the income that you earned while working. As a result, you'll want to shift your financial assets away from equities and into income-producing assets such as bonds, dividend-paying stocks, and income annuities.

Of course, there are no guarantees that stocks will return more than bonds, even though they have done so during very long periods of time.Over shorter time periods, stocks can certainly suffer, and even over periods as long as 10 years, stocks can trail bonds. For instance, from February 2002 through February 2012, U.S. stocks gained less than 5.0% per year, on average, whereas high-quality U.S. bonds gained an average of 5.5% per year and endured much less volatility. Against a backdrop like that, it might be tempting to ignore stocks altogether.

At the same time, however, it stands to reason that during very long periods of time, various asset classes will generate returns that compensate investors for their risks. Because investors in stocks shoulder more risk than bondholders, and bondholders take on more risk than investors in ultra-safe investments such as certificates of deposit, you can reasonably expect stocks to beat bonds and bonds to beat CDs and other "cash"-type investments during very long periods of time. In turn, that suggests that younger investors with long time frames should have the majority of their investments in stocks, whereas those who are close to needing their money should have the bulk of their assets in safer investments such as bonds and CDs. During the 10-year period through September 2013, stocks, bonds, and cash have settled into a more familiar pattern, with stocks outpacing bonds by 3 percentage points on an annualized basis, and both stocks and bonds leaving cash in the dust.  

What I've discussed so far is called strategic asset allocation--meaning that you arrive at a sensible stock/bond/cash mix and then gradually shift more of your portfolio into bonds and cash as you get older. Of course, it would be ideal if we could all position our portfolios to capture stocks' returns when they're going up and then move into safe investments right before stocks go down. In reality, however, timing the market by, say, selling stocks today and then buying them back at a later date is impossible to pull off with any degree of accuracy--so much so that most professional investors don't try it.

Maintaining a fairly stable asset allocation has a couple of other big benefits: It keeps your portfolio diversified, thereby reducing its ups and downs, and it also keeps you from getting whipped around by the market's day-to-day gyrations. An asset-allocation plan provides your portfolio with its own true north. If your portfolio's allocations veer meaningfully from your targets, then and only then should you make big changes.

To find the right stock/bond mix, you'll need:

Step 1
Before determining a target asset allocation, start by checking out where you are now. Log on to Morningstar's Instant X-Ray tool. Enter each of your holdings, as well as the amount that you hold in each. (Don't include any assets you have earmarked for short-term needs, such as your emergency fund.) Then click Show Instant X-Ray. You'll be able to see your allocations to stocks (both domestic and international), bonds, cash, and "other" (usually securities such as convertibles and preferred stock), as well as your sector and investment-style positioning.

Step 2
The next step is to get some guidance on where you should be. Find the asset allocation in this document that corresponds to your anticipated retirement date. Remember, this allocation corresponds to your long-term goals (for example, retirement assets), not your emergency fund or any shorter-term savings that you've earmarked for purchases that are close at hand.

Step 3
The allocations in the document mentioned above are a good starting point, but you can further fine-tune your asset allocation by asking yourself the following questions:

Are you expecting other sources of income during retirement, such as a pension?
Yes: More equities
No: Fewer equities

Does longevity run in your family?
Yes: More equities
No: Fewer equities

Are you expecting to need a fairly high level of income during retirement?
Yes: More equities
No: Fewer equities

Have you already accumulated a large nest egg?
Yes: Fewer equities
No: More equities

Is your savings rate high?
Yes: Fewer equities
No: More equities

Is there a chance that you'll need to tap your assets for some other goal prior to retirement?
Yes: Fewer equities
No: More equities

Do you want to leave assets behind for your children or other loved ones?
Yes: More equities
No: Fewer equities

If still working, are you in a very stable career with little chance of income disruption?
Yes: More equities
No: Fewer equities

Excerpted with permission of the publisher John Wiley & Sons, Inc. from 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances. Copyright (c) MMX by Morningstar, Inc.

See More Articles by Christine Benz

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