Asset Allocation & Diversification: Stocks, Bonds, or Cash

Welcome to the ‘Understanding Retirement Planning & Investing’ series! If you’ve missed the first few posts be sure to check them out!

Understanding Asset Allocation & How to Choose Mutual Funds

Knowing that I’m a financial advisor, I’ve come to learn that most people really don’t have the slightest clue as to what asset allocation means.

It’s quite common for people in their 20s or 30s to have an asset allocation that’s suited for somebody in their 60s or 70s (100% in cash – i.e. CDs or money market accounts) because they’re scared of what’s going on in our economy and they don’t want to lose any of their money.

Instead of the traditional investment approach of buying LOW and selling HIGH, most ignorant investors do the exact opposite!

Conventional Wisdom

The Average Joe falls victim to emotion and makes decisions based on FEAR and GREED. There is no doubt that mass media plays a large part in this, so it’s likely that the more you read the paper and the more you watch the news, the MORE likely you are to make irrational decisions based on FEAR.

The Basics of Asset Allocation

To first understand Asset Allocation, we must learn what different assets types there are to invest in (particularly in regards to saving for retirement):

  • Stocks
  • Bonds
  • CDs
  • Precious Metals
  • Real Estate
  • Annuities
  • Commodities

Once you have a firm grasp of understanding that there are only a certain number of things you can invest in when saving for retirement, the next step is understanding that your Asset Allocation ultimately determines your rate of return over time.

Asset Allocation simply means what PERCENTAGE of your money should be tied
up in assets like the ones I just mentioned: stocks, bonds, CDs, etc.

Research, through numerous studies, have shown that 91% of a person’s RETURN on investment is based on ASSET ALLOCATION.

Knowing our ignorance in this regard, most Americans’ initial reaction when choosing an investment option in their 401(k) or IRA is to look at MorningStar and find out which funds have their coveted 5-Star Rating.

Others may jump to Kiplinger to find out the hot mutual fund for 2012.

Some may simply look at the 1, 5, and 10-year return on a particular fund and make their investment decision solely based on that.

Unfortunately this method of choosing investments gives you no real understanding of why you own a particular stock or mutual fund; therefore you really have no reason to hold onto it which causes you to sell it when things don’t go well and look for the ‘the next best thing’.

The Greater the Risk, The Greater Your Potential for Return

I mentioned at the start of the post that it’s extremely common to see somebody in their 20s, 30s, or 40s to be invested extremely conservatively based on the fear that consistently gets pumped into our minds.

However, the people that “play it safe” are really hurting themselves in the long run. If conventional wisdom tells us to ‘buy low and sell high,’ and you do the exact opposite by trying to time the market via getting in when things are going well and getting out when things are going poorly, you’re likely to miss the majority of the gains the stock market is going to give you.

Furthermore, if you always keep your money “safe” then it’s highly unlikely you’ll outpace inflation and realistically (whether you realize it or not) you are losing money – well, you’re losing purchasing power.

While risk tolerance does need to be taken into consideration, some people simply need to be coached on how to properly invest. Being in my 20s, I understand that I’m not going to NEED my retirement investments for a long period of time and this tells me that I can take a little more risk than most people.

Here is a visual that I use to help people understand how their retirement investments should be allocated along the assets of Stocks, Bonds, and Cash:

At the base of the triangle you have Cash (i.e. Money market accounts, CDs, or other “safe money” investments). These types of investments really have little to no risk but they also have little to no reward.

Bonds are a little more risky because there is a chance of default but they tend to give you a higher return over time than the “safe money” counterparts.

Lastly, as we all know Stocks are the most risky, however they tend to give you the best chance for long-term growth.

How You Should be Allocated

Ultimately, your particular allocation (again, the percentage of money that should be tied to stocks, bonds, or cash) will ultimately be based on a few things:

1. Your Risk Tolerance

2. Your Goals and the Rate of Return You NEED to Earn to Get There

3. Your Time Horizon (i.e. how long do you have before you NEED the money?)

The greater return a person needs to get in order to achieve their goals, the MORE they should be weighted towards stocks (when I refer to stocks, I mean stock-based Mutual Funds).

The LONGER somebody has until they retire (or until they need the money), the MORE you should be weighted towards stocks. Maybe an allocation of 95% stocks, 5% bonds…or something along the lines of 80/20 (stocks/bonds).

However, as you near retirement, it’s wise to shift your asset allocation towards a more conservative approach and take on a more bond-based allocation. In the next lesson I’ll discuss the 3 phases of investing, in which your phase on investing ultimately determines your asset allocation.

Choosing Funds in your 401(k) Made Easy

Ultimately, how you break down investment choices SHOULD go in this order:

1. Determine Asset Allocation – which percentage of your money should be tied to stocks, bonds, and cash. This answer lies in the following questions:

  • How much time do you have until you want to retire or until you NEED the money?
  • What is your risk tolerance?
  • What are your goals and what RATE OF RETURN do you NEED to get there?

2. Diversify – once you know you should be allocated 80/20, then you look to diversify the 80% tied to stocks and the 20% tied to bonds.

This could be a whole different lesson but there are a few choices of stocks you could look for:

  • Large Cap Stocks – these are the BIG companies most of us would recognize (Google, Coca-Cola, etc). They have a market capitalization of OVER $10 billion. These are traditionally less risky but sometimes don’t earn as much.
  • Mid Cap Stocks – market capitalization of $2-10 billion. Slightly more risky than large-cap stocks, but an edge on return over time.
  • Small Cap Stocks – capitalization of $300 million to $2 billion. Definitely more risky than the other two, but over time they’ve shown to yield a higher rate of return.
  • International stocks – despite struggles overseas it’s wise to have some portion of your assets tied to international. If you think about it, the MAJORITY of our assets are already tied to US markets (your job, house, etc), so when you’re diversifying it’s smart to always have some investments that aren’t solely based on what’s happening in the US.
  • Emergency Markets – these stocks are a little more risky because they’re invested in countries that the title suggests: “emerging.”
  • Growth Stocks & Value Stocks – value stocks tend to have a higher rate of return over a LONG period of time, but they’re more risky simply because they’ve been ‘undervalued’ for one reason or another.

Once you diversify your 80% stock allocation in the above categories, then you need to break up the 20% bonds:

  • Government Bonds
  • Corporate Bonds
  • International Bonds
  • Short, Intermediate, and Long-Term Bonds
  • High-Yield Bonds (or ‘junk bonds’)

3. Select the Mutual Funds – after you have a grasp of your Asset Allocation and your Diversification approach, THEN it’s time to check out your fund options and choose which funds will best suit you based on:

  • MoringStar or Kiplinger reports/ratings
  • The fund’s return over the last 1, 5, and 10-year periods (sometime it’s good to look at their return since inception as well).
  • Internal fees (expense ratio) and Turnover Rate – turnover is the percentage of the investments in that paricular portfolio that WON’T be in that fund next year. The lower the expense ratio the better.
  • Fund Manager – how long as the fund been managed by the same person?
  • How long has the fund been around? It’s it brand new or has it weathered a few “storms”?

There is little doubt that MOST people don’t want to mess with this process, thus we end up with people that (1) try to time the market based on FEAR AND GREED, (2) don’t know what they own which further lends itself to buying and selling, and (3) end up with people that get “burnt” by the market and choose to stay invested in cash and therefore never outpace inflation.

If you need help choosing funds in your 401(k), then there is nothing wrong with paying a professional a few dollars to help walk you through the process. I am biased, because it’s what I do, but I think it’s definitely worth the money in the long run!

For those that are too cheap to pay somebody, or for those that don’t really want to do the leg-work themselves, I’ll discuss Target Date funds in an upcoming post.

About the Author

By , on May 18, 2012
Andy Tenton
Andy is a 30-something New Yorker who turned his financial life around. He took charge of his finances, got out of debt, and is now working his way toward financial success. He is the publisher of

How to Become Rich e-Course

Budgeting 101


  1. ShortRoadTo says:

    Let’s hope the risk = return mantra continues to be true in the future. That mantra hasn’t been correct over the last 12 years .

  2. Thanks for the valuable information! I’m pretty new to investing, so any easy to read advice is great

  3. Edward Antrobus says:

    What kind of asset allocation would you recommend for somebody with low risk tolerance, but 4 decades till retirement? I’ve had a Roth for a couple of years, but I only ever invested $500 in it. Just started saving this year, not much but it’s a start. Fortunately, my retirement needs are pretty modest. I’ve calculated it to be about $25,000 in 2012 dollars.

  4. Shilpan says:

    I’ve made good money with the small cap in the past, but those securities are highly risk prone. I really like Vanguard Total Stock Market Index Fund. Thanks for the great article Andy.

  5. Katie says:

    I agree w/ Erika about hiring you to help me when I’m ready to invest. 🙂 Right now I feel like I am okay with taking a bigger risk but at the same time I don’t have a clue which stocks to buy. I am just random.

  6. jefferson says:

    Great write up, Andy.. You are seriously a guru when it comes to investing and retirement.

    I recently dumped a large portion of my low-performing investments (they were way up for a while, but I ended up breaking even at the time).. A large portion was tied up in a futures fund that was heavy in on facebook/twitter. .Luckily I dumped the stock prior to the IPO, because it has seriously tanked since..

  7. Great post with a ton of information! All very well put and understandable. I already understood most of this but I think most people could understand this post regardless of their investment knowledge.

  8. This is a lot valuable information. You pointed out that young investors who do the play-it-safe game are hurting themselves in the long run. It makes sense not to take crazy risk, but if you’re young and obviously have a long investment horizon, taking some risk that is manageable is essential.

  9. CultOfMoney says:

    I’m actually a big fan of the method “buy high, and sell higher” and I do also try and time the market based on fear and greed, to some point anyway. I’ve mentioned my method before, and research has shown good results using a simple system like shown in the Ivy Portfolio to liquidate when prices cross the 10 month moving average.

    You’ve got great information here on asset allocation and fantastic tips both in the article and comments about dollar cost averaging, target date funds (of which I’m not really a fan of), and diversification. I think you need to expand on the risk tolerance in a future post too! Thanks a bunch for a great post.

  10. Holy cowwwwww Andy. This post is so informative and concise it rocks my socks off. Thanks for this. Bookmarking forever.

    Now, I totally understand everything about investing and my options, but the asset allocation still trips me up. I use a Target Retirement Fund 2045 and 2050 as my Roth IRA and 401k. I understood that with this type of fund, I do not have to do any re-balancing, etc. What are the pros and cons of this type of fund?

    • Andy says:

      That’s a really good question Erika. So, the target date funds have an asset allocation based on the “target date.” So, if you have a fund with a TD of 2045 or 2050 you will be VERY aggressively invested, maybe 90/10 or 95/5 (stocks/bonds). So they basically do the asset allocation for you based on the target date.

      The problems I have with TD funds are:
      1) An older person SHOULD NOT be in a TD fund unless they’re on pace to retire. People in their 50s that have done a poor job of saving will be in a “conservative” allocation if they choose a 2020 TD fund. Well, this specific person (who is behind on saving) probably needs to take on more risk, so they can earn a greater return, so they can actually retire when they want. Basically, the TD funds aren’t specific to you, they assume you’re saving the proper amount and have accumulated the proper amount based on your age and the TD fund you choose.

      2) They haven’t been around long so you don’t really know their long-term track records. I really haven’t seen any TD funds that perform as well as the portfolios people could have put together if they did it themselves (if they chose the individual Mutual Funds in their 401ks instead of just going with the TD). With that said, I have seen a few but I’m been quite disappointed in the performance in most of them.

      However, the great thing about them is that if you don’t know what you’re doing, they’ve done all of the allocation and diversification for you. So that is certainly a plus.

      And specifically for you, since you’re far enough out from retirement, my first issue with them wouldn’t really apply. They’re just really bad for people that are behind on their retirement savings…but since you have so long and you should be well on your way, they will have the proper asset allocation for you.

      Hope that helps!

      • VERY informative. I think I want to hire you to help me invest once I am ready to start doing so (I don’t consider these TD funds as investing really…I just kind of set it and forget it). I chose the 2045 and 2050 so that it would be a greater risk, but I’m thinking of just leaving it in there while I am in school.

        Are there any negatives of doing this?

        Thank you SO much!

        • Andy says:

          No, for you I really do think it’s fine. Sure, you could do better with other funds but those TD funds DEFINITELY better than trying to pick some on your own.

          I would just beat you up if you were in cash, CDs, money market, or in a heavy bond-based allocation.

  11. Excellent post, especially the point about younger investors not taking enough risk. Your point about mutual fund expense ratios is also important. For 401(k) participants, there will be new disclosures about fees and expenses from their companies due out later in the year. I suggest to all that they review these disclosures carefully.

  12. First, who you callin’ “ignorant?” 🙂 (buy high, sell low–my investing signature it seems)

    Seriously though, a great primer, and love the visuals. You must be a fantastic benefit to your clients.

  13. Modest Money says:

    Thanks for this little lesson Andy. It was a good reminder of how lousy my retirement investments are right now. I became convinced that I was going to be buying an apartment sometime soon. So the financial advisor at my bank convinced me to put all that money in the most secure investment. Now it’s earning next to nothing. I’m going to have to rethink that plan and be more realistic about my real estate plans. It sounds like I’d be much better off diversifying that investment a bit and take on some level of risk with some of it.

  14. King says:

    What a coincidence, I did my own 401k allocations yesterday! I turned off the AutoPilot feature.Thanks for the tip about expense ratio; I did not even look at that yesterday. Now I’m wondering if I should switch funds.

    As for my Roth, I’m paying an advisor to manage that. We are funneling some money into the Roth every month. Not max. But I don’t think my advisor is buying stocks every month, he may be letting the money build up into a bigger pile, before trading. Is that ok? Would you be doing the same thing?

    • Andy says:

      That’s a great question King! I’m glad I could help with the expense ratio – all mutual funds will easily show this information. Especially if you use a site like Morningstar, all of that info will be available if you enter the fund ticket symbol or the actual fund name.

      401(k) providers are actually being required to start revealing their internal fees. They’ve never been required to do so, so it’s really good for the consumer that the government is finally forcing them to show how much they’ve been charging people. It should be happening any time now and I’ve actually seen a few employers already start doing it.

      Regarding the Roth: I think it’s best to buy as often as you can (well, within reason). I probably should do a post on this sometime but there is something called ‘Dollar Cost Averaging’ which is a VERY BIG deal when investing over the long term. Basically instead of only buying in 1, 2, or 4 times a year, the more often you can buy the closer your return will be to the market’s.

      So, let’s say you bought in twice during the year, once in June and once in December. Unfortunately for you the market was at the peaks each of those times that you bought. While the market may have made some money throughout the year, you only bought in at the high points so you’re not going to see a return.

      The reverse is true…you could get lucky and buy during the low times of the year and have a great gain.

      However, with dollar cost averaging you really take this whole gambling/lucky thing out of the equation. If you’re constantly buying (once or twice a month like when you contribute to your 401k) then you get a truer average of your buy-in cost.

      I hope that makes sense! It’s a little confusing and I could explain it a little better with visuals. I’ll make sure to do a post on it here in a few weeks and feel free to ask me to clarify if I see you on Sunday. 🙂

  15. Excellent post Andy, love your greed/fear image!
    Unless the world is ending, one needs to stay put and let the storms pass. Of course, this takes a balanced portfolio with sector diversification.

  16. Thad makes a great point about trying not to panic. A lot of people are probably doing just that because the S&P 500 is down around 100 points over the past month, but its healthy. Look where it was 6 months ago. Corrections are normal and its just a buying opportunity.

  17. I think the best thing to remember is to not panic. We don’t make good decisions about finances when we are in a panic. I believe that learning to not panic is a learned behavior.

    Hey, did you get the email I sent about the movie passes you won?

  18. Michelle says:

    You make this all very easy to understand! I still have a hard time with investing. I analyze everything so much until it drives me crazy.

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