What is asset allocation, and how do you pick yours?

Asset allocation is how you split your investments between stocks, bonds and cash. Pick it from when you need the money and how big a drop you can sit through, then write it down as percentages, like 80% stocks and 20% bonds.

It is a split by percentage

You describe your allocation as percentages of the total, like 70% stocks, 25% bonds and 5% cash. The dollar amounts follow from the percentages.

Two questions set it

Your time horizon is how long until you need the money. Your risk tolerance is how much loss you can accept, both in money and in nerves, in exchange for more growth.

More stocks means a bumpier ride

Stocks have more growth potential over long periods but can drop sharply. Bonds usually swing less and grow less. Cash is steady but can lose value to inflation.

It drifts, so you rebalance

When stocks rise faster than bonds, your stock share grows past your target. Rebalancing means shifting back, by moving money or by aiming new deposits at the part that fell behind.

Start with when you need the money

Your time horizon is the number of years until you plan to spend the money. With a long horizon, you have time to wait out bad years, so you can hold more stocks. With a short one, a drop could land right when you need the cash.

A simple rule that works for most goals is to keep money you need within about 5 years in savings, a CD or short-term bonds. Money you won't touch for 10 or more years can lean heavily on stocks. In between, a mix of both is common.

Then decide how much drop you can take

Risk tolerance is part ability and part nerve. Ability is whether a drop would actually hurt your plans, which depends on your emergency fund, job security and other savings. Nerve is whether you would hold on or sell in a panic.

Try a stress test. Multiply your stock dollars by 30%, a large but realistic drop for a bad stretch. If seeing that loss on your statement would push you to sell, choose a lower stock share. A mix you can keep through a crash beats a bolder one you abandon.

Rough starting points

There is no single right answer, but common starting points look like this. With 25 or more years to go, 80% to 90% stocks. With 10 to 25 years, 60% to 80% stocks. Under 10 years, gradually less, with more in bonds and cash as the date nears.

One old rule of thumb says your stock share should be about 110 minus your age, so 81% stocks at 29. It is a starting point, not a rule. Your income, other assets and comfort with risk matter more than a formula.

One goal, one mix

You can have different allocations for different goals at the same time. Retirement money 35 years away might be 90% stocks while a house fund for next year is all cash. Mixing the two into one pot leads to a bad mix for both.

Within each goal, count all the accounts that serve it. If your 401(k) is 100% stocks and your IRA is 100% bonds, your retirement allocation is whatever the two add up to.

The easy way to hold your mix

You need only two or three funds: a broad stock index fund (or one US and one international), and a broad bond index fund. Put each fund's share of your money in it and you are done.

Or let one fund do it. A target-date fund or a balanced fund holds a set mix of stocks and bonds and rebalances for you. If you use one, keep it as your only fund in that account, so the mix stays the one it was built to hold.