2 Key Questions When Setting Your Asset Allocation

Note: This article is part of Morningstar's 2021 Portfolio Tuneup special report.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com.

Your portfolio's mix of stocks and bonds will have a huge impact on how it behaves, but for many investors, setting a portfolio's asset allocation seems like a wild guess. And in some ways it is; we don't know what stocks, especially, will return. We only have long-term market history to go on. But investors can get themselves into the right ballpark for their stock/bond mix by thinking about risk tolerance and risk capacity.

You can determine your risk capacity by thinking through your proximity to spending your money. If you have a long time horizon until you'll begin spending, you can afford to be in higher-return, higher-volatility assets like stocks. But if you're going to begin spending soon, you'll want to hold at least some of your portfolio in lower-volatility assets like cash and bonds.

Risk tolerance relates to your ability to psychologically withstand the fluctuations in your investments and your whole portfolio. Even if a portfolio is in line with your risk capacity, it's not a good asset allocation if it keeps you up at night or if you retreat to more conservative holdings at an inopportune time.

Both concepts are equally important in setting your asset allocation, so you need to balance them against one another.

Thanks for watching; I'm Christine Benz for Morningstar.com