Slicing Up the Stock and Bond Pies

Step 4: How Do I Determine the Right Allocation for My Portfolio?

The allocation decision within these market segments depends on your risk profile: your risk tolerance, return needs (growth and income) and time horizon. There are many different combinations that can match an individual's profile, and everyone's profile differs. Table 2 presents a summary of the risk and return characteristics of the market segments and shows one approach to allocating among the segments. The final decision must rest on your own judgment and what you are most comfortable with.

Here, however, are some thoughts to consider:

• A core position consists of at least a 50% commitment. For each major asset class, the most conservative segment should serve as a core. Using this approach, at least 50% of a stock portfolio would be invested in the stocks of larger firms, and at least 50% of a bond portfolio would be invested in high-quality bonds (government bonds, high-quality corporates and municipals).
• At least 10% of a portfolio must be committed to a market segment to have a meaningful effect. Using this approach, at least 10% of a stock portfolio would be invested in small firm stocks and 10% in foreign stocks, while for a bond portfolio, at least 10% would be invested in high-yield bonds. This would also mean that the maximum commitment to each core segment by a conservative investor would be 80% of a stock portfolio or 90% of a bond portfolio. Conservative investors can reduce the risk in the core segment of their bond portfolio even further by shortening its average maturity.
• Given the above limits, commitments to the non-core market segments could range from 10% to 40%, depending on an investor's risk tolerance and preference for a particular market segment. For instance, an aggressive investor who favored smaller stocks over foreign stocks may have a stock portfolio that consists of 50% large-firm stocks, 40% small-firm stocks and 10% foreign stocks.
• Keep in mind the goals of diversifying among market segments, which is to reduce the major risks of the major asset classes (stock market risk for stocks and interest rate risk for bonds). The various market segments move in different cycles; one may do much better than another over certain time periods. Diversifying reduces the risk that you will guess incorrectly which market segment will do well in the near future.
• Make sure that you take into consideration any income needs. Small stocks and many international stocks don't pay much income; income from high-yield and foreign bonds may be higher than for high-quality bonds, but also more variable.
• Make sure that you understand the added risks of the non-core segments, particularly the downside risk.
• These considerations should never override the most basic investment principle—never invest in anything you don't understand.

The objective at this point in time is to expand on the broad asset categories. Decisions on investment style—for instance, should you invest in value stocks or growth stocks—and on specific stock or bond selections are made at a later stage, after you have decided who will handle the selection decisions.