During an economic crisis it is especially important to have a solid, well thought out investment plan that supports your financial goals. The foundation of a good financial plan is your asset allocation which provides a guideline on how much you should place in different investment categories. The most significant component is the mix between stock and interest earning investments.
Your allocation needs to be consistent with the level of risk you are willing to take, especially in times of uncertainty, like these we are currently experiencing. Create a portfolio that supports your financial goals, provides liquidity for short-term needs, and gives you peace of mind. Establish an asset allocation that you can stick with through a major drop in the stock market. An overly aggressive portfolio can lead to an emotional reaction, to a significant drop in the market, resulting in selling at a loss.
On the other hand, you need to take enough risk to grow your portfolio to support your financial goals and stay ahead of inflation.
From a broad perspective your portfolio falls into three major buckets, cash, non-cash interest earning and stock. The first step in creating an allocation is to decide how much cash is needed to cover an emergency fund and your expenses over the next twelve months. In normal times an emergency fund of about four months is generally adequate. However, you may need to increase this during the COVID-19 crisis if you have any concerns that your job or health may be at risk.
The second step is to fill your second bucket with CDs, bonds, and bond funds to cover expenses, that are not covered with income, for five to seven years. This is the minimum amount you should keep in interest earning investments. This will provide you with enough reserves to avoid tapping into stock during a market decline.
Once your short and long-term liquidity needs are covered, decide how much risk you are comfortable taking. This will drive the percentage of your portfolio to be invested in the stock market. If you are in your 30’s or 40’s you may be comfortable with 30 percent in interest earning (including cash) and 70 percent in the stock market. As you approach retirement you may want to transition to an allocation of 40 percent in interest earning and 60 percent in the stock market. This is different for everyone depending on your unique situation and risk tolerance.
The stock portion of your portfolio should be well diversified with a mix of companies of different sizes, in different industries and geographies. The stock portion of a typical portfolio usually contains at least 50 percent in large U.S. companies.Create a diversified portfolio that you can stick with through all market conditions. Review your plan periodically to make sure it still supports your financial goals and rebalance annually to stay on track to your plan.