According to various studies, the first of which was published in Financial Analysts Journal in May, 1991, stock selection accounts for only 4.6 percent of investment returns, while market timing is responsible for only 1.8 percent. Meanwhile, the proportion of assets allocated to stocks, bonds and cash was found to account for 91.5 percent of investment returns.
Proper asset allocation ensures the portfolio represents the investor’s risk tolerance. If too much of the nest egg is held in stocks and the market tanks, the investor is more likely to panic and sell. In doing this, the investor buys high and sells low.
Picture three buckets. The first bucket should contain money that will be withdrawn from the portfolio within three years. The second bucket contains funds that will be used in four to ten years. And finally, the third bucket holds money that will not be needed during the next ten years.
The money in the first bucket should be invested in liquid, cash-type investments such as money market or savings accounts. This is short-term money which should not be exposed to market fluctuations.
The second bucket, holding intermediate-term money, should be invested in bonds. Although bonds fluctuate in value, they are not as volatile as stocks. However, bond returns are usually a significant improvement on cash-type investments. Constructing a bond ladder by purchasing bonds that mature each year will refill the cash bucket once a year.
The long-term money in bucket three is invested in stocks. This seven-year money is the growth portion of a portfolio and will fluctuate with the market. An investor doesn’t need to worry about a down year in the market because these stocks will not be sold for at least seven years, which is plenty of time for the market to recover. In fact, it took the U.S. stock market seven years to recover from the Great Depression. Thus, an investor utilizing this strategy would have survived the worst investment climate in history without selling assets at a loss.
This strategy provides a consistent source of income when it is needed. Money from the cash bucket can be used to meet living expenses, a bond will mature each year to replenish the cash bucket, and stock positions can occasionally be sold to replenish the bond portfolio. If the market has a poor year, stocks can be held for an extended period to avoid selling during a down market. This strategy will increase the probability that funds will be available to meet any planned expenses ranging from retirement, to business expenditures, to college tuition.
The market pullback of 2008 forced many investors to sell investments at an undesirable time. Speak to your financial professional about developing an asset allocation that represents your risk tolerance and provides sufficient liquidity to prevent having to sell your nest egg at a loss.