A Well Tailored Asset Allocation

Whether your plans are all sewn up or you’re just starting to put the pieces in place, your company’s retirement plan provides a convenient way to save money for your future. It also offers a variety of investment choices. But making sure your account is invested in a way that best suits your needs is up to you.

Classic Patterns

Deciding on an appropriate asset allocation — the way your account is divided up among stocks, bonds, and cash alternative investments — is a matter of balancing the potential for earnings and investment risk.

Historically, the long-term returns of stocks have beaten the returns of bonds and cash alternatives. In the short term, however, stock returns have been very volatile. So there’s a substantial risk of earning poor returns or losing money when you invest in stocks. Bond returns, by comparison, are less volatile, and cash alternatives are much less volatile than stocks.

Note that cash alternative investments may not be federally guaranteed or insured and that it is possible to lose money by investing in cash alternatives. Returns on cash alternative investments may not keep pace with inflation, so you could lose purchasing power.

A Three-piece Strategy

There is no single ideal asset allocation. The mix that’s right for you won’t be the same as the one that suits your cousin or your aunt or even your best friend. To find an asset allocation that’s right for you, look at three key things: your investing time horizon, your risk tolerance, and your overall goals.

Measuring Time Horizon

Determining your investing time horizon is straightforward — it’s the amount of time you have left to invest before you’ll need your money. If you’re putting money away so you can take a big vacation in five years, your time horizon is five years. Five years is considered a relatively short time frame, so you’d most likely put a sizeable portion of your money into conservative investments with a low risk of loss.

If you have lots of time before you intend to retire, you’ll want to make the most of those years by building up your savings. You may be comfortable investing a large portion of your account in stocks because you’ll likely have time for your investments to recover from any downturns.

As your time horizon shrinks, you become more vulnerable to a stock market downturn. As retirement gets closer, consider reducing your exposure to risk by shifting more of your account to less risky bond and cash alternative investments.

Measuring Risk

Deciding how much to allocate to the various asset classes also depends on your risk tolerance. One aspect of your risk tolerance is your attitude — how you feel about taking risk. For example, if you were asked to choose between going white-water rafting and canoeing on a lake, your answer would indicate how much risk you’re inclined to take. The same is true with investment risk. If the potential for higher returns far outweighs the risk of losing money, you may be inclined to invest heavily in stocks.

But that’s only part of the picture. You may feel comfortable with a high level of investment risk, but there are other factors to consider. For instance, if your spouse’s job situation is tenuous, it may be wise to reduce your risk exposure until things are more settled financially. Ask yourself how much you’re willing to lose in a year. Any time investment losses would leave your financial situation in jeopardy, your capacity to take risk is reduced.

Measuring Goals

The final part of the asset allocation equation is figuring out how much you need to save. If you have big plans for retirement, you’ll need a substantial nest egg. So you may be willing to accept more risk in return for potentially higher returns. On the other hand, if you have other retirement income sources (additional savings or investment accounts, a pension from a former employer, or the like), you may be inclined to invest more conservatively.

Key Alterations

As these three factors change, revisit your asset allocation to see if it’s still appropriate. You may need to adjust the balance of risk and potential reward in your retirement portfolio. Keep in mind that most experts suggest holding at least some stock investments, even after retirement, to provide some measure of growth or, at a minimum, to help you stay ahead of inflation.