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Your asset allocation is your personal mix of stocks, bonds, and cash. But the way that you invest is more than just a colorful pie chart, and can be the deciding factor in how successfully you meet your goals.
That’s why assessing your risk tolerance and picking an asset allocation model is so important. And it’s one of the first things you should do before you invest, for these three reasons.
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1. Your asset allocation affects how much you have to invest
Your asset allocation could impact how much you’ll contribute to your accounts every year. And the more you can potentially earn in investment return, the less you’ll need each year.
If you’re invested in a conservative portfolio that earns 4% each year, adding $10,000 each year could get you to $110,061 in nine years. If that rate of return increases to 6%, you could save $9,000 and get to $109,627 in the same amount of time. If you earned 8%, you could decrease your annual contribution to $8,000 and reach $107,892 in nine years.
Earning a higher rate of return may be more feasible, though, when you are younger. You have a longer time horizon before you will need your assets for retirement and plenty of years to recoup money lost in a stock market crash. As you age and near retirement, a year of big losses could be more devastating. You may want a less risky investment strategy that requires larger contributions.
2. Your asset allocation helps determine the volatility in your investment portfolio
How you’re invested could also play a role in how much your accounts move up and down during different investment cycles. In bull markets you will see more gains, but in bear markets you will experience bigger losses.
For example, in 2008, a portfolio made up of 100% large-cap stocks would’ve lost 37% of its value. Adding 25% bonds to that portfolio would’ve reduced the losses to 29.06%, and a 50% addition would’ve brought it down to 21.12%
In the following year, though, investors with more conservative portfolios would’ve seen their accounts gain less when the markets recovered. You would’ve gained 26.47% if you owned an all-stock portfolio, 21.33% if you had 75% stock, and 16.2% if you had 50% stock.
3. Your asset mix drives your investment return
Predictions of average rates of return that you could receive are driven by asset allocation models. So the difference between you earning 8% and 10% each year on average boils down to how much stock you own.
Historically, between the years 1926 and 2019 a portfolio containing 50% bonds and 50% stocks has earned 8.29% on average. A portfolio that consists of 100% stocks has earned 10.29% over the same time span. If you added $10,000 to a portfolio every year and it grew 8.29% on average for 20 years, your account would grow to $511,766. If that same portfolio earned 10.29%, it would grow to $652,871.
If you are someone who doesn’t have a lot of guaranteed income sources in retirement, you may end up depending primarily on your retirement assets. Earning more can mean a more comfortable lifestyle instead of worrying that you won’t have enough.
Risk tolerance
Picking the right asset allocation model should start with examining your appetite for risk. How have you reacted to volatility in the past? When the stock market plummeted in March 2020, did you have nerves of steel? Or did you sell everything and start investing again when things got better?
Even if you have a high tolerance for risk, your risk-taking ability may be low. Things like not having an adequate emergency fund may result in you selling out of your investment portfolio if an unexpected expense pops up, even if your holdings are trading at a loss.
Choosing an asset allocation model that is right for you is important. But it shouldn’t be decided solely based on how much your accounts could grow each year, or how much you can contribute. It also determines how much you could lose or gain in a particular year, and how well you can stay invested through negative stock market years. And your time in the market could ultimately play a huge part in your success over the long term.
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