The SEC's investor education pages tie the choice to two personal facts: how long until the money is needed, and how much loss the investor can tolerate, financially and emotionally, without abandoning the plan. A long horizon can sit through several downturns and so can hold more of the volatile classes; a short one cannot wait for a recovery. Each class answers a different need: shares for growth, with larger swings; bonds for income and generally steadier values; cash for liquidity, with inflation as its cost. The mix of the three, plus anything else the investor holds, decides most of how the portfolio will feel in a bad year.
Keeping the mix on target
Rebalancing is the uncomfortable step, because it means selling what has done well and buying what has lagged. It is also what stops the risk an investor chose from turning into a different risk nobody chose.
Allocation and diversification are related but distinct: allocation picks the buckets, diversification spreads money within and across them. Low-cost index funds make it practical to fill each bucket broadly, and time in the market lets compound interest do its work. The idea is central to investing and portfolio management and to long-range personal finance and planning.
- Set targets: a weight for each class and a tolerance band around it.
- Spread inside each class: many issuers, sectors and regions rather than a handful of favourites.
- Rebalance: restore the targets when drift leaves the band or on a fixed calendar; investor.gov notes that some advisers suggest doing it every six or twelve months.
- Revisit when life changes: a shorter horizon or a new dependant justifies new targets, a poor quarter does not.