Monday, June 18, 2007

Asset Allocation in Your 20's

This is the first post in a new series titled Personal Finance in Your 20's that will be running throughout this week. The second post in the series will be published tomorrow and will cover the subject of insurance in your 20's.

When deciding how to invest your money in your 20's there are two main factors that you should carefully consider. Those two factors are: (i) your investment time horizon; and (ii) your tolerance for risk.

Let's talk about investment time horizon first. The amount of time for which you are investing your money will make a very big difference for the type of investment you should choose. For example, if you are saving up for a big vacation next summer, invest your money in safer, less volatile assets such as a CD or a high yield money market account. On the other hand, if you are saving for retirement, and have a time horizon of 40 years or more, you probably want to invest your assets much more aggressively. As a rule of thumb, the more time you have before you will need to withdraw your money, the more investment risk you should be willing to accept.

With respect to your tolerance for risk, only choose investments with which you are comfortable. If you can't sleep at night for fear you might lose your money, that investment is probably not for you. If you are not sure what your risk tolerance is, start by taking one of the many investor profile tests you can find online, to help you answer that question. This is one example of such a test.

For the rest of this post, let's assume that you are in your mid 20's and that you are saving for retirement. First of all, if that's the case, congratulate yourself. You are well on your way to financial security. Now, let's get serious. With 40 years of investing ahead of you, you can afford to invest aggressively and take some risks. I am now in my mid thirties, and my asset allocation currently looks like this. With your time horizon even longer than mine, you can afford to be even more aggressive.

If I were in my twenties and starting a portfolio, I would allocate my funds as follows:

25% large cap stocks
25% small and mid cap stocks
30% international stocks
10% real-estate
10% diversified bonds

In each case, I would choose a highly diversified index fund with low expense ratios (take a look at Vanguard which specializes in such funds). The impact of expenses on your portfolio over 40 years of investing is profound, and one way that will practically guarantee better returns on your investment is minimizing investment costs. With respect to the funds themselves, I would choose the same funds in which I am currently invested. In any case, be sure to keep your portfolio sufficiently diversified.

Finally, you may be interested to know how other people in their 20's are saving for their retirement. This document from EBRI provides a great deal of additional detail. However, in terms of asset allocation, the average 401(k) investor in his twenties has a portfolio that looks like this:

Equity Funds: 51.9%
Company Stock: 10.4%
Balanced Funds: 15.5%
Fixed Income Securities: 20.2%
The remaining 2% are not accounted for in the document.

So, how did I invest in my 20's? The sad answer is that I kept my money in "safe" CDs and money markets, thus missing the big bull market of the 90's. My tolerance for risk was way too low. You could say that I used to have a fear of investing. I got over my fear of investing just in time for the big DotCom bust... yeah, it was fun. BUT, whatever doesn't kill you makes you stronger. I now have a very good sense of my investment goals, and am comfortable with the risk profile of our portfolio.

For more information about some of the topics covered here, take a look at the following posts:

Diversifying into International Markets
How People in their 20's Invest for Retirement

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