What percentage of my savings shall I invest in stocks? And what percentage shall I invest in bonds or keep in cash or other investment classes like real estate?
The questions in what to invest and how much of your savings to invest are on top of the mind of every investor. Let's have a look at a much quoted rule of thumb on this topic and what type of tools are available for this on the web.
A much quoted rule
A much quoted rule of thumb and a simplified asset allocation guide on how much to invest in stocks and bonds is the age related rule:
Allocate a percentage of your portfolio equal to 100 minus your age to equity stocks, and invest the rest in bonds. For example, if you were 45 years old, then you would hold 100 - 45 = 55 or 55% of your investments in stocks or stock funds, and 65% percent of your assets in bonds or bond funds.
The background argumentation for this model is that when large cap stocks are held for periods of 15 years or longer, they in general have a better return than bonds. But because of the higher fluctuations in stock prices than in bond prices, stocks offer a higher risk and should be a smaller part of your investments when getting closer to retirement. The assumption is that you need the money when you retire and you cannot afford then that your stocks have lost a lot of value.
The following issues are often highlighted around this simplified model:
- It only takes into account two assets classes: stocks and bonds. It does not take cash, real estate funds and the difference between large and small cap stocks into account?
- It looks upon bonds and bonds funds as part of the same class while both have considerable different characteristics; more on this later.
- It does not take into account how wealthy the investor is and with what risk levels he or she is comfortable. Wealthier investors are often prepared to invest a larger portion of their wealth into more risky but also more rewarding investments than less-wealth investors.
- It forgoes on the idea that younger people have not only more time to make up earlier losses but have also have more time to lose even more than older people since they have more time till the standard retirement age.
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In summary, this much quoted rule of thumb is a very simplified model that could be plainly wrong for a lot of people.
On the internet, you can also easily find automated asset allocation advisors like this one on the CNN Money website. Based on your inputs regarding time horizon, risk tolerance and flexibility, it provides you with a suggested assets allocation over bonds, small cap stocks, large cap stocks and foreign stocks.
A good aspect of the availability of tools like this is that it may prevent people who have no better information to put all their savings in just one asset. Following now such a model, they in any case diversify their investments. But this does not mean that they are only taking risks that they are comfortable with. The problem is that they maybe do not know or understand what risks they are taking.
The issue for me with following an advice like this would be that it is very much a black-box tool. You know what you put in and see what you get out of it, but you do not get an understanding how the tool came to the results. For me to sleep well at night, I want to understand why I would invest in a certain way. Just following the advice of a web application won't do it for me since it does not provide me clarity on what type of assumptions are behind the advice that I am getting and if those assumptions are even valid for me.
When we want to answer questions like "in what assets to invest" or "how much of our savings to invest", we consider at Stock Trend Investing the following aspects:
- Two different types of "risk"
- Your risk tolerance
- Inflation and Interest Rate
- Bonds, Options and other Assets
- Your presence in the market
Do you want to consider these aspects as well?
Author: Trend Investing
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