Buying two stocks and one bond does not provide the same amount of diversification as investing in two stock funds and one bond fund. A company’s stock could easily tank while the overall market is doing fine; it happens all the time. It’s better to invest in a few funds and their hundreds of underlying stocks. 

You should consider two questions when deciding your stock, bond and cash allocations: 1) What is your portfolios’ time horizon; and 2) How comfortable are you with risk? The answers to these questions constitute your “risk-return profile.” We came up with three examples to demonstrate how these questions can direct your asset allocation decisions. In all of these scenarios, diversifying within the broad stock (i.e. U.S., Developed International, Emerging Markets, Real Estate, etc.) and bond (Long-Term, Short-Term, Cash, etc.) categories will limit risk further.

On Risk

There is no straightforward way to figure out how comfortable you are with investment risk. You have to consider you taste for adventure and then trust your gut. You can start by asking yourself if you prefer to drive in the right lane with your hazards on, or to weave through four lanes at 85 mph. Do you order the oxtail or stick to spaghetti and meatballs? It’s likely that your tolerance for investment risk resembles your predisposition for risk in general.

In addition to considering your tolerance for risk, you must also consider your capacity for risk. If you are investing money that you are not going to use for many years (see the 20-30 year timeline described below) then your risk capacity is probably high. You can afford to increase your allocations to riskier stock markets and ride them through the markets’ ups and downs. But if you are going to need a good chunk of your cash in the next few years then you should focus on protecting your assets with less risky investments. Your capacity for risk is quite low as you cannot afford to be in the middle of a down market when you look to cash out (see the 2-5 year timeline described below.)

Though we suggest some asset allocation “starting points” below, you should dial the risk of your portfolio to a place that feels right to you. You might range up to 15 percentage points above or below our recommended allocations.

Remember this: a well allocated portfolio of investment funds should not keep you up at night and should not require daily, or even weekly, monitoring. You should be comfortable with your strategy and prepared for both good and bad market conditions. If all is truly right in the world, you will feel proud of your investment decisions and even have some fun making them.

Example I: Buying a House in 2-5 Years

Let’s say you plan to buy a house in the next few years and want to save enough to make a down-payment. You don’t want to invest everything in a high interest savings account because you want to try to grow your savings at a higher rate and buy the bigger house on the block. Plus, you want to be sure that your return outpaces inflation. The best way to consider this is to set a monthly savings target and stash your dough in cash or cash-equivalents. This means savings accounts and certificates of deposit. If there is money left over, you would invest it based on your long-term horizon or other goals.

This split of near-term cash and long-term investments should provide some protection to your savings goals for the house. Even if you're cash is protected, you might consider limiting your investment in riskier asset classes (i.e. stocks) since it is difficult to predict their performance over short periods of time.

A conservative 40% stock, 60% bond and cash allocation is a good starting point to consider. You might ramp the stock allocation up or down a bit depending on how comfortable you are with risk.

Example II: Paying for College in 15-20 Years

Maybe you are starting to save for your newborn’s college tuition in a 529 college savings plan. With a longer time horizon you can probably afford to take on more risk while pursuing higher returns. Stock markets tend to jump up and down over short periods of time, but they have a history of trending upwards over longer periods.

Increasing your allocation to stocks might cause your portfolio to fluctuate in value more often, but it will increase your chances for benefitting from the strong long-term performance records of these assets. A 70% stock, 30% bond and cash allocation is a good starting point to consider. Again, you might increase or decrease the stock allocation depending on your tolerance for risk.

Example III: Investing for Retirement in 30 – 50 Years

Most of us put a little bit away every year in 401(k)s and IRAs so that we can afford poolside Mai Tais and Botox gimlets in our old age. Fortunately, a tradition of positive long-term stock market performance and the magic of compound returns mean a small investment can transform into a large retirement fund in 30 – 50 years.

What is the magic of compound returns? Well – let’s put it this way. If you invest $1,000 when you are 20 years-old, add another $1,000 every year after, and make an average 8% return, you will have $301, 505.56 in your portfolio at age 60. If you start the same investing regimen when you are 30, you will only have $132, 408.52 in your portfolio at age 60. The difference is much greater than the $10,000 more you invested.

If you have a 30 – 50 year investment horizon, you can afford to bet that while the stock markets might swing up and down over short periods of time, they will post positive returns over longer periods. Time is on your side. That said, you should not completely forgo a bond and/or cash allocation because your portfolio’s performance will benefit from having some downside protection. An 80% stock, 20% bond and cash split is a reasonable allocation to consider.

And remember, you will want to revise your allocation as time passes, your investment horizon shortens, and the “5:00 Early Bird Special” becomes a realistic savings technique.