Your asset allocation mix represents your personal decisions about how much of your portfolio to allocate to various investment categories, such as stocks, bonds, and cash. How much you allocate to each category depends on your financial objectives and personal circumstances. However, it is a percentage that is likely to change over time. As your needs for safety of principal and a steady income stream become more important, the percentage of bonds you own is likely to increase. Some factors to consider when deciding how much to allocate to bonds include:
Your risk tolerance. The advantage of including both stocks and bonds in your portfolio is that when one category is declining, the other category will hopefully help offset this decline. One way to assess the percentage of bonds to include in your portfolio is to look at how holding varying percentages of stocks and bonds would have impacted your average return.
Your time horizon. The longer your time horizon for investing, the more risk you can typically tolerate, since you have more time to overcome any significant downturns in your portfolio. Certainly, individuals with short time horizons, perhaps five years or less, should be very cautious about how much is allocated to stocks. But as your time horizon lengthens, you can theoretically add a higher stock mix to your asset allocation. However, in all situations, make sure you’re comfortable with the percentage allocated to each category.
Your return needs. Your need to emphasize income or growth is likely to change over your life. When you are trying to accumulate significant assets for a goal far in the future, you may want to allocate more of your mix to stocks. However, when your needs for a predictable income stream become more important, such as when retirement approaches, you may want to allocate more to bonds.
Once you decide how much to allocate to bonds, you need to ensure that you diversify within the bond category. With bonds, there are many ways to diversify, including:
By maturity dates. You can purchase bonds with short (three years or less), intermediate (three to 10 years), or long (10 years or longer) terms.
By issuer. You can purchase bonds issued by the federal government and its agencies, municipalities, corporations, or international issuers.
By type. There are numerous types of bonds, including callable, zero coupon, inflation protected, and high yield.