Understanding Personal Finances – Spring 2024
Asset allocation is key to any successful investment strategy. It’s all about how your portfolio for a given goal is divided among various asset classes (investment categories). The most widely used asset classes are cash equivalents, fixed-income securities and equities.
| Asset class | Examples | Historical risk and return profile* |
|---|---|---|
| Cash equivalents |
Bank savings accounts Short-term certificates of deposit (CDs) U.S. Treasury bills Money market funds |
The least risk and the lowest returns |
| Fixed-income securities |
Bonds Bond funds Fixed annuities |
Moderate risk, moderate returns |
| Equities |
Stocks Stock funds |
The most risk and the highest returns |
| * For each asset class in the chart, the risk-and-return profile shown is in relation to the other two asset classes. | ||
Your portfolio for any given goal should reflect an asset allocation that’s tied to three factors:
For short-term goals (one to three years into the future), you typically need an asset allocation that poses low risk, even though it may also produce a low return. For medium-term goals (three to seven years away), a moderate-risk, moderate-return allocation is often appropriate. For goals that are seven or more years away, which may include things like a college education for your child or your retirement, you might choose an allocation that poses greater risk but offers the potential for a higher long-term return.
Once you’ve set up an asset allocation for your portfolio, you should review the allocation at least once every 12 months, or whenever you experience a major life event, like getting married or divorced or adding a child to your family. If the goal for which you created the portfolio has changed, you may want to change the allocation accordingly.
Once you’re within about 10 years of retirement, to reduce risk, you may wish to move some of your retirement assets into more conservative investments, which would involve relying less on stocks and more on fixed-income securities and cash equivalents. But don’t lose sight of the fact that you’ll want your nest egg to last the rest of your life. To stay ahead of inflation as you approach and then enter retirement, you’ll generally need to be invested not just for the income you’ll need as a retiree, but also for some long-term growth.
Because different assets produce different investment results, over time, your portfolio may drift from the asset allocation you want. This can happen even if you continue to invest according to plan and don’t withdraw from your investments or transfer assets among them. Before too long, assets that are currently growing more quickly will occupy a bigger piece of your portfolio, while assets with less robust current performance will occupy less room in your mix.
To address this natural shift, you can rebalance your portfolio, which means moving balances among investments to return to your intended asset allocation.
Let’s say you began with an allocation of 60% stocks/40% bonds. Since then, your bonds have performed better overall than your stocks, and you now have a mix of 55% stocks/45% bonds. To get back to your original 60/40 mix, you can transfer some balances from bonds to stocks.
Typically, you’ll incur current-year taxes on any gains realized when you transfer balances within an investment account that is neither tax-deferred, like an account in a 401(k) or other workplace retirement plan, nor tax free, like a Roth IRA (in most cases). To avoid triggering taxes, you could rebalance gradually by changing the investment direction of future interest, dividends and capital gains on the account, as well as new contributions to the account. You could also sell some “losers” at the same time, recognizing that capital losses offset capital gains. Up to $3,000 of excess capital losses (up to $1,500 if you’re married and filing separately) are deductible against ordinary income each year.
Your financial planner on the EY Navigate Planner Line can offer you more information and insights to help you choose an appropriate asset allocation, monitor it going forward and rebalance when needed.