Getting Started with Asset Allocation

If you're new to investing, recognize the merits of using low-cost index funds, but you're not sure how to allocate your long-term savings among various types of index funds, this information is for you.

Asset allocation basics
While there are many ways to divide investment assets into different categories, there are two main classifications: stocks and bonds.

Here's what you need to know: Stocks are riskier but have the potential for higher rewards compared with bonds. Also, stocks and bonds don't always move up or down together. That's it. That's enough info to get you started. There's plenty more to learn about stocks and bonds if you want, but you needn't wait any longer to start investing.

The starter asset allocation
If you're just getting started, here's a fine way to allocate your funds until you're ready to make things more complex:

  • 60% in a total US stock market index fund
  • 40% in a total US bond market index fund

The biggest criticism I hear over this approach is that it's too conservative for younger investors and to aggressive for older investors. My response: Then change it to 80% stocks/20% bonds (for young investors) or 40% stocks/60% bonds (for older investors) if that's the conclusion you've reached.

Another criticism is that there's no international (or emerging markets, REITs, TIPS, or whatever else you like). Okay, so add them if you want and can satisfy fund minimums. Use the starter allocation as a starting point. As your knowledge, understanding, and comfort level increase, feel free to make changes.

If you're just starting out without a lot of money, the greatest influence on your account balance will not come from your asset allocation; it will be your own contributions. If having 20% in international stocks would have earned you an extra half percent on your $5,000 portfolio your, you missed out on $25. (And it could just as easily cost you half a percent, in which case you saved $25.)

When your balance is small, what you contribute matters more than what you contribute to. You may even reach the conclusion that the 60/40 starter allocation is works for you long-term.

If you don't have enough money saved to meet the minimum investments, then save in a high-yield savings account until you do. (For example, you can implement the starter allocation using VBINX with $3,000.)

Next steps
Once you have more money invested for longer periods of time, asset allocation decisions become more significant. Just keep in mind that increased stock market exposure doesn't always mean a greater chance of achieving your financial goals. The added risk of additional stock may work against you, and in some cases can decrease you chances of achieving your financial goals. I'm not talking about market volatility; I'm talking about the very real chance of experiencing a less favorable, long-term outcome.

From here, you can continue to educate yourself about the effect of asset allocation on your own financial goals and priorities, or you can seek some help from a professional. And by seek some help from a professional, I'm not necessarily talking about having them manage your money; you can hire a financial planner just to recommend an appropriate asset allocation for you that you can implement yourself.

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Lizabeeth
Lizabeeth
10 years ago

I would never recommend someone using a mutual fund. They should instead use an ETF. ETF’s are much easier to trade, and typically have much lower costs than mutual funds.

Paul Williams
Paul Williams
10 years ago

Great intro to asset allocation, Dylan.

@Lizabeeth (#1): There’s not a huge difference in cost between Vanguard index funds and Vanguard ETFs. The trading costs of ETFs can easily outweigh the savings in expense ratios – especially when you first start investing. It doesn’t matter that ETFs are “easier to trade” – you don’t need to be able to sell in the middle of the day if you’re investing for the long term.

Shane
Shane
10 years ago

Lizabeeth,

Can you please elaborate on the difference between a mutual fund and ETF? I’m not sure what the difference is, and I don’t know what an ETF even is!

Thanks,
Shane

ClaireTN
ClaireTN
10 years ago

@1 Lizabeeth, ETFs usually have lower expense ratios, but you incur a brokerage fee to exchange them. Also, many retirement plans don’t give participants access to ETFs.

I very much appreciate seeing this basic introduction to asset allocation on the blog. My spouse and I use Vanguard for our Roth IRAs and have been very happy with their low-cost index funds. Right now our allocation is 75% stocks and 25% bonds. We keep 30% of our stock allocation in international stocks.

ClaireTN
ClaireTN
10 years ago

@3 Shane, ETF stands for “exchange traded fund.” It is like a mutual fund that can be traded throughout the business day. The price fluctuates as the prices of its underlying assets do. With a normal mutual fund, you buy and sell it at the price in place at the close of the trading day. (Disclaimer: I’m not an expert!)

Lizabeeth
Lizabeeth
10 years ago

I didn’t think about the trading fees because I do not pay anything for trades. I bank with Bank of America and use their brokerage service. They have free trades if you keep a savings/checking balance of $25,000. Also, I know I was in a mutual fund two years ago that charged about 1.25%. The ETF I am currently using is at .2%.

Mike Piper
Mike Piper
10 years ago

“When your balance is small, what you contribute matters more than what you contribute to.”

Bravo!

The flip side, of course, is that if you’re 60 and about to retire, you’d darned well better put some serious thought into matching your asset allocation with your goals.

Lizabeeth
Lizabeeth
10 years ago

@Shane #3

Look up ishares.com. They are typically who my husband and I use.

Nicole
Nicole
10 years ago

“Use the starter allocation as a starting point. As your knowledge, understanding, and comfort level increase, feel free to make changes.” I really like this. When I first started out, I got paid 2x a year (graduate stipend) had all our money in a low interest savings account at a local bank. A friend of mine who had worked at a bank told me that was dumb and to stick it in a CD at the very least. A difference of 4% annual interest is a LOT when you’re only making 18K/year. As I gradually got more sophisticated and had… Read more »

ClaireTN
ClaireTN
10 years ago

@6 Lizabeeth, 1.25% is a high ER. Vanguard’s total stock market mutual fund has an ER of .18%. Whether you use ETFs or mutual funds, you are right to keep an eye on expenses.

Tomas Stonkus
Tomas Stonkus
10 years ago

If you are starting out, keeping things simple is key. However, this is a bit of an oversimplified approach. When you are investing money, it is crucial to know how much risk you are willing to accept and what the chances are that you will need this money in a year, two years and so on. Giving yourself a time line will change many things. To begin with you will know how risky you can be. If you are young and going to keep the money in the account for the long haul then just invest it all in the… Read more »

misanthropope
misanthropope
10 years ago

corporate bonds seem to be a pretty bad asset class, almost certainly unworthy of a 40% allocation for any investor at all. There is a reasonable body of evidence that suggests a smaller (half) allocation of cash (federal short-term debt, not actual federal reserve toilet paper) produces all the salutary effects of the corporate debt, with a much lower opportunity cost. _Bull’s Eye Investing_ (Mauldin) discusses this, and i am certain i have encountered it at various other places in my public library (though i can come up with no other citations off the top of my head) luck to… Read more »

Nicole
Nicole
10 years ago

I would like to hear more about this VBINX…

ami | 40daystochange
ami | 40daystochange
10 years ago

Dylan: I’m no expert, but it feels like something is missing.

Do you put cash and near-cash (everything from MMAs and CDs to T-bills) in a separate category? What about gold? During the recent financial craziness, some friends did better than average b/c of funds moved to cash-like accounts or gold (I didn’t know until recently that that was an option!)

Would be interested to know your thoughts on whether other categories than stocks and bonds should come into play in asset allocation.

Dylan
Dylan
10 years ago

There are many different ways to allocate and many legitimate opinions supporting them. The point of the starter allocation is to provide one example of one sensible way to get started with asset allocation that is easily implemented. There is a lot of available information and tons of articles about asset allocation, but few present an actionable starting point. That was the goal of this post. @ Lizabeeth: “They have free trades if you keep a savings/checking balance of $25,000.” If the interest you could be earning on that money is over 1% less there than some place else, it… Read more »

Pey
Pey
10 years ago

I often hear the “80/20” figure quoted for individuals who are younger with a greater risk tolerance and longer investing timeline. Is there a general consensus in the investing community regarding this ratio?

I am 26 and have about 95% of my investment in stock. (About 20% in ETF, about 40% in value investments with dividend distributions and about 40% in riskier small cap investments.)

I understand I have a long investment timeline, so is 95% stock allocation too much in your mid twenties?

John
John
10 years ago

One thing to consider when deciding on asset allocation is whether this is going to be your primary source of income in retirement. I have mutual funds through a state employee deferred compensation plan, which I expect to be a supplement to my defined-benefit pension (and social security). Since it’s not expected to be my primary source of income, I feel I can be less conservative – I am 50, expect to work to ~65, and have about 70% of my deferred comp account in stocks.

Booyah
Booyah
10 years ago

I just don’t see why people who are very far away from retirement need to be in bonds. If you have the stomach to live through the wild ups and downs of equities, I would ask you to add bonds only as you reach around 10 years close to retirement. I am 35, and I am invested 100% in stocks. I had no problems seeing my portfolio plummet in 2001-2002 and in 2008; in fact I DCA every month into my 401K, IRA and taxable accounts. I am far ahead with my 100% equities as opposed to holding any bonds… Read more »

Regular Reader
Regular Reader
10 years ago

Dylan, and JD,

I’d like to see a post and discussion on tax-efficient investing for those of us who have already maxed out our contributions to the tax sheltered accounts.

I know Vanguard has different categories of tax efficient stock mutual funds, and tax free muni-bond funds.

Any thoughts?

Mark Wolfinger
Mark Wolfinger
10 years ago

Hello Dylan,

“I’m not talking about market volatility; I’m talking about the very real chance of experiencing a less favorable, long-term outcome.”

It’s the same old story.

The investor does not have to take the chance that there will be an unfavorable outcome. The investor can protect his/her stock market investments by adopting conservative option strategies.

It’s far safer than hoping asset allocation works as well as it did in the past.

I’ll trade limited upside for a guaranteed limited downside. Most conservative (frugal) people should feel the same.

Regards,

Nicole
Nicole
10 years ago

I think the point this author is making is that it doesn’t really matter what stock/bond allocation you start with. Just start with one. Dave Ramsey is similar– he suggests a 1/N strategy with four different indexes/ETFs… something like 1/4 growth, 1/4 blue chip, 1/4 international, and 1/4 something else (bonds? the S&P 500? I don’t remember). It overweights international and underweights growth according to conventional wisdom (eg what I read on fool.com or in money magazine) for someone my age, but it isn’t too shabby. Once you’re more comfortable with investing, then you can figure out the exact percentages… Read more »

Daniel Sesh
Daniel Sesh
10 years ago

Great post! I’m 33 and just started investing this past summer. So far it seems that ETFs are a great choice for those of us just starting out. They are easy to trade online and can offer great diversification. There are many different ETFs out there, and my wife and I have decided to split our allocation in three pieces. 42.5% in stocks; 42.5% in bonds and 15% in cash equivalents (online savings accounts and CDs). This allocation has worked out great so far. Also, for the nerdy of us numerous studies have indicated that passive index funds (i.e. most… Read more »

DonB
DonB
10 years ago

I’m generally with Lizabeeth; I usually recommend that people start with ETFs, at least for their “independent” investments (i.e. those not in a work sponsored plan). If you plan to make IRA contributions one time per year to arrange your taxes right, transaction costs at a discount broker are modest and ETFs have rock-bottom expense ratios otherwise. Pick a broker that has free reinvestment of dividends as partial shares and you can pretty cheaply get reasonable lazy diversification with less money than mutual funds would require. I like something with 3 investment categories: US Stocks (VTI), Non-US Stocks (VEU), and… Read more »

Tyler Karaszewski
Tyler Karaszewski
10 years ago

There’s no reasoning given for any of the advice in this article at all. Why 60/40? Why sometimes 80/20 or 40/60? Why *would* I want international investments? Why would I bother with this “asset allocation” stuff at all? What am I trying to accomplish by doing any of it? Personally, my entire 401k is in a single index fund (FUSEX). I guess I could change that, but, eh, why bother? I don’t really see what it gets me. It’s all essentially play money for the next 30 years anyway. It’s hard for me to worry too much about money I… Read more »

Steven
Steven
10 years ago

@23 Tyler Given your age, you’re at the time where the most important thing is to save. I’ll agree with you there, because in the short term, a few percent here and there doesn’t add up to much when you consider the small balances we young professionals have. The problem with “setting and forgetting” leads to problems. Most (near) retirees lost much of their account balances is because they were too heavily invested in stocks when the stock market crashed. This was due to ignorance, laziness, procrastination, and optimism. No one changed their allocation, because they didn’t know any better… Read more »

Olivia
Olivia
10 years ago

“… starter allocation using VBINX with $3,000.” I am just curious, why VBINX? Why not VSCGX or VSMGX? If I don’t have 3k, can I use VGSTX?

I want to memorize this: “When your balance is small, what you contribute matters more than what you contribute to.”

Thanks for the post!

John DeFlumeri Jr
John DeFlumeri Jr
10 years ago

Stock market investing is another form of gambling.

John DeFlumeri Jr

Adam
Adam
10 years ago

“Stock market investing is another form of gambling.”

And what do you propose people put their 401(k) and IRA money in that will come out ahead of inflation by the time they retire? I’m seriously curious.

Pey
Pey
10 years ago

“Stock market investing is another form of gambling.” I just came back from Vegas last month. At the same time I was losing 100% of my $50 “investment” playing craps, my stocks were slowly bringing in dividends, modest gains and impressive returns. Granted, no one knows the direction the market will take us, but with a fair level of certainty we can be sure the market will continue to churn upwards in years to come. There has never been an extended period of time (decades) where the market declined. Here’s the bottom line: Anyone who refers to the stock market… Read more »

Free Life
Free Life
10 years ago

This post comes at a time right when I am considering changing the funds my 401k is invested in. I struggle with deciding on a right mix of stocks and bonds. I also want to have a little exposure to international stocks and I’ve read the benefits of investing in small, mid, and large cap stocks as well as value and growth stocks. When I try incorporating all these assets into my 401k I would end up with probably 8 different funds. Instead I’m choosing a few asset classes and sticking to them. I won’t have exposure to everything but… Read more »

Pey
Pey
10 years ago

“And what do you propose people put their 401(k) and IRA money in that will come out ahead of inflation by the time they retire? I’m seriously curious.” There are a few options, of course you may not like them, but I will list them below. Along with the options, the benefit is listed alongside. Please let me know if you have questions. 1. The mattress. This location is ideal for anyone who likes the smell of green during the hours of slumber. Additionally, if your bills are crisp, the firm nature of money inside the mattress may prevent back… Read more »

Daddy Paul
Daddy Paul
10 years ago

I like how you tackle asset allocation. I think asset allocation is one of the hardest parts of investing to get your arms around. 60 40 may be to conservative for many people under 50. The important thing is asset allocation first.

Steven
Steven
10 years ago

@31 Pey He said he wants to stay ahead of inflation. The money under the mattress loses value over time due to inflation. Each dollar is still worth a dollar, but it buys less. @32 Daddy Paul Asset allocation is secondary. What most important is how much you are willing to risk for a chance to get more in return. However much returns stocks can offer is useless unless you can stomach losses, like this current market. How many people exited at the worse point? How long will it take to recover their losses, especially with the gains made after… Read more »

Pey
Pey
10 years ago

“The money under the mattress loses value over time due to inflation. Each dollar is still worth a dollar, but it buys less.”

Not so, Steven. The sentimental value accumulated from years of lying on your money is quite substantial. You should try it sometime; the benefits are quite clear to us money-in-the-mattress hoarders. In time, you’ll see.

Also, it might do you good to look up the definition of “sarcasm” in the dictionary and do your best at noticing when others are using it.

Nicole
Nicole
10 years ago

Just think, Pey, how much more your back would hurt if you’d invested in gold!

Dan
Dan
10 years ago

I’d like to recommend “What Works On Wall Street” by James O’Shaughnessy. The author is a numbers freak and does an exhaustive study of what worked over the last 70 years….the end result for average investors such as myself is to stick with a standard asset allocation based on index funds and STICK WITH IT. If you think you can time it, you’re screwed. Also check out “Winning the Loser’s Game” by Charles Ellis…not an easy book to read but it explains that you cannot win against the Big Boys, so just try to not lose (as opposed to trying… Read more »

Christian Poecher
Christian Poecher
10 years ago

@23 Steven: [quote] The only real problem I have with the post is this paragraph. “… I’m not talking about market volatility; I’m talking about the very real chance of experiencing a less favorable, long-term outcome.” [/quote] Dylan is right, although it is not straight forward to understand. A “favorable outcome” means lots of average yield with a minimum of risk. That is usually a contradiction, but by mixing asset classes you can get a better yield per % of volatility. You can make diagrams of those two values, too. Plot volatility on the horizontal axis and average yield on… Read more »

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