2024 was a banner year for the stock market.
The S&P 500 ended 2024 with a 23.3% gain, following a 24.2% gain in 2023. If you’ve invested in the entire market over the past two years, your portfolio probably looks pretty good right now.
At the same time, shares of Nvidia rode the AI boom and increased by 170% in 2024. Would it have been better to go all in, riding the AI wave instead of the entire market?
You can get lucky once or twice, but it’s impossible to get on and off the train at the right time every time. Unlike private equity markets, the stock market is efficient, with all information readily available – in other words, there is no beating it.
Because of this, the safest and wisest bet is to set an allocation based on your risk tolerance and cash flow that can be managed passively.
How to Set Your Asset Allocation
We believe that your needs and cash flow should dictate your asset allocation, not the other way around. You can break the process of setting your allocation and investment strategy into the following steps:
- Assess your risk tolerance
- Evaluate your cash flow needs
- Choose your asset classes and an allocation
- Rebalance periodically
- Consider taxes
- Adjust as needs change
Assess Your Risk Tolerance
Your first step is to assess your risk tolerance.
Risk measures the variation of outcomes, the amount that an investment could go up is equal to the amount it could go down. While the booms for certain stocks are inspiring, riding the wave up puts you at risk of crashing down.
Taking a broad market approach, you can still refine your strategy based on your appetite for risk:
- Lower Risk: If you’re risk-averse, you might prefer a portfolio with a higher allocation to bonds, money market funds, or other fixed-income securities. These typically offer lower but more stable returns.
- Moderate Risk: A balanced approach might include a mix of stocks (e.g., 50-60%) and bonds (40-50%).
- Higher Risk: If you can handle more volatility, you might lean towards a higher equity allocation, possibly 70-100% in stocks, focusing on growth or index funds.
If you are risk-averse/have a short timeframe, tilting your allocation toward bonds and other fixed-income securities may make sense. If you have a long investing horizon and can handle a bit more volatility, then stocks may make more sense.
Here’s a simple breakdown:
- Conservative: 70% bonds, 30% stocks
- Moderate: 50% stocks, 50% bonds
- Aggressive: 80% stocks, 20% bonds
To help determine your risk tolerance, we have a free risk questionnaire that you can take to assess your risk tolerance.
Evaluate Your Cash Flow Needs
Your cash flow and needs will impact how you invest and your investing timeline. We take a three-bucket approach to wealth for our clients:
- Money you need now: This represents the cash reserves that you need at any given moment. You should put these in the highest-yield money market account you can find to maximize your return.
- Money you need in the near term: This is the money you save up for larger expenses in the near term. It could be for a mortgage, college fund, or home renovation. We recommend putting this in a stable investment like a Treasury ladder to lock in current rates while avoiding state income tax.
- Money you need in the long term: This is where you invest for the long term based on your risk tolerance.
Viewing your money through this lens makes it easier to assess the risks of your investments. Volatile investments like stocks are not the wisest of choices in “near money,” while slow-growing bonds may come with an opportunity cost in the long run.
Choose Your Asset Classes and Determine an Allocation
Once your risk tolerance is determined and you have broken out your cash needs, you can choose your asset classes and determine an allocation.
Again, the three-bucket approach is helpful for selecting asset classes based on your needs.
In the near term, the highest-yield money market account is optimal, while Treasuries are a good fit for the medium term. In the long term, you have more options for your allocation as this portion of your portfolio will have the longest timeline to grow:
- Stocks: Consider index funds or ETFs for broad market exposure. For example, the S&P 500 for U.S. equities or MSCI World for global stocks. While you could buy VOO and leave it at that, Direct Indexing can give you finer control over what sectors of the market you invest in and provide tax benefits.
- Bonds: Government bonds (like U.S. Treasuries) for safety, corporate bonds for higher yield with more risk, or bond index funds for diversification.
- Real Estate: REITs or real estate funds if you seek income and diversification.
Rebalance Periodically
While the S&P 500 had an incredible run from 2023-2024, don’t forget that it dropped 18% in 2022.
Even a broad approach in the entire market will result in dips here and there, so periodically rebalancing your portfolio can ensure your asset allocation remains balanced, according to your needs and matching your risk tolerance.
Consider Tax Implications (And Reap Benefits)
If you take a balanced approach to the market, taxes pose the greatest threat to your portfolio’s gains. There are a few strategies we’d recommend you consider to minimize your tax burden along the way:
- Place high-dividend assets or those with frequent capital gains in tax-advantaged accounts like IRAs if possible.
- Gift shares of stock to reduce your taxable income and re-purchase at a higher price to lower your cost basis, minimizing taxes when you sell the position in the future.
- Harvest tax losses by selling positions that dropped to offset any other investment income.
These are just a few of the tactics you can use to maximize the gains in your portfolio while minimizing the impact taxes can have.
Adjust as Needs Change
Sooner or later, your “long-term” money will become “near-term” money, so it’s important to leave room to adjust your allocation and risk tolerance as your lifestyle and circumstances change.
Earlier in life, it’s fair to have a higher tolerance for risk in favor of growing your portfolio. This might result in an allocation in your long-term money that is 80% stocks and 20% bonds. Later in life, though, you may want to shift that to 50-50, depending on your outlook and tolerance for risk. Ultimately, this is a personal decision based on your tolerance for risk and time horizon.
Ready to Discuss Your Allocation?
While this guide can instruct you on the basics of the passive approach to investing, it is a starting point, not the final destination.
Your personal situations, risk tolerance, and cash flow concerns will be unique from others, so it’s important to discuss them with a qualified professional. If you would like to discuss your current investing approach and goals, please reach out to us from our website.
This information is general in nature and should not be considered tax advice. Investors should consult with a qualified tax consultant as to their particular situation.
All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability, or completeness of, nor liability for, decisions based on such information, and it should not be relied on as such.
The views expressed in this commentary are subject to change based on market and other conditions. These documents may contain certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance, and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.
M3 Family Office LLC (“M3 Family Office”) is a registered investment advisor. Advisory services are only offered to clients or prospective clients where M3 Family Office and its representatives are properly licensed or exempt from licensure.