30 Day Investing Challenge, Day 18: Determine Your Asset Allocation
You’re well into this 30 day challenge so let’s recap what you’ve done so far:
Day 1: Create a vision for your life
Day 2: Get your financial house in order
Day 3: Know your FI number
Days 4-6: Set short, medium, and long term goals
Day 7: Do an inventory of your current investing accounts
Day 8: Evaluate your current investment options
Day 9: Choose a brokerage firm
Days 10-12: Know what accounts to use for short, medium, and long term goals
Days 13-16: Know what stocks, bonds, index funds, and ETFs are
Day 17: Determine how much you should invest
Now that you’ve learned about investment options and how much you should invest based on your timeline, lifestyle, and income it’s time to talk about asset allocation. Asset allocation means how much of your portfolio you have invested or saved in stocks (including index funds and ETFs), bonds, and cash or cash equivalents (which just means assets that can be converted to cash quickly with no loss of the original amount you invested). To be clear, we’ll be talking about asset allocation when it comes to retirement specifically. You can use this same model for other long term goals, but short and medium term goals have specific types of investments you can choose, which we’ll get to in the next few challenges.
The Simple Formula
If you want to keep it simple there is a broad formula that many people use to determine their asset allocation for stocks. It goes like this:
110 - [your age] = % of your portfolio in stocks.
Example if you’re 35 years old: 110 - 35 = 75, so your portfolio should be split into 75% stocks and 25% bonds and cash.
Caveat: your portfolio shouldn’t go beyond a 60/40 split or it’ll be too conservative to keep up with inflation.
This works for most people because it “smoothes the ride.” Let me show you what I mean:
The graph above is showing the performance differences between VBMFX Vanguard’s bond ETF (“Portfolio 1”), vs. VTSMX, Vanguard’s S&P 500 ETF (“Portfolio 2). As you can see a 100% stock portfolio had a rough ride for 20 years, but it still trended upwards and in the end increased the portfolio value by several thousands of dollars above and beyond VBMFX. Bonds on the other hand also trended up and had way less ups and downs. In essence the ride was “smoother.” However, as you can see investing in bonds meant that the portfolio was not as valuable towards the end. This is why a mix is a great strategy because it gives you both that smoothness and higher returns.
The Even Simpler Formula
That being said, I take a different tactic preferred by J.L. Collins, author of The Simple Path to Wealth:
When contributing to retirement, go 100% in stocks, specifically a total stock market or S&P 500 index fund.
Five years out from retirement, switch your portfolio to 75% stocks and 25% bonds.
Keep that allocation until the end of retirement — meaning, rebalance your portfolio ever year so it keeps the 75/25 split
Explanation: when you buy different asset classes, over time your asset allocation percentages will start to shift in one direction or another. You may start with a 75/25 stock/bond split, but after it year it may be 62/38 or 86/14. Rebalancing is the act of selling the asset that has too much and using that money to buy the asset that doesn’t have enough. So if your portfolio is 62% stocks and 38% bonds, you’ll want to sell 14% of those bonds and use the money to buy stocks.
What Should You Choose?
If you’re the kind of person who will panic sell when the market “crashes” then I would go with the first option. Even if this is you, I do want to impress upon you why I put the word “crashes” in quotes. News outlets will say the market is crashing when the Dow Jones Industrial Index or DIJA , an index that tracks a whopping 30 companies out of 4,000+, is down a measly 3% because fear sells. But a 3% dip is literally nothing. The true tests are when something like Black Monday happens, which is when the stock market dropped over 22% in a day in 1987. It came right back up again, but if we had the internet and stock tracking apps like we do today we’d have a panic on our hands. All this to say: you may not make as much money, but you’ll lose even more if you’re prone to selling when you shouldn’t.
However, if the thought of a 22%+ dip makes you scoff, you might be comfortable with the second option and you’ll certainly make more money over the long term. Just be aware that if you’re portfolio gets to $1 million a 22% drop is $220,000… in one day. Make sure you’re prepared for that. My trick: pretending like I’m dead.
Action Step: Pick Your Asset Allocation
Your action is to choose from the above two options and write down your asset allocation percentages (if applicable). You’ll need this number later.
I’ll see you back here tomorrow for your next challenge: What to invest in when you have a short term goal.
Want to dive in deeper? My investing workbook “Your Journey to Freedom” will show you how to build the life of your dreams and teach you the fundamentals of the investing world.
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