Why It Works

Updated on April 18, 2007.

SMARTMONEY has embraced the idea of "buy-and-hold" investing from our earliest days. Simply put, we believe that if you pick good companies, they remain profitable and you see no long-term reason to sell them, then hang on. Over time, they're bound to make you money.

We don't treat it as some sort of religion — we're as tempted as the next guy to throw a little money at a high-flying biotech stock. It's really more of a practical matter. Unless you've got a lot of experience and interest, it's simply unrealistic to expect that you'll be able to "time" the market's short-term swings by jumping in and out of stocks. That's best left to the professionals — or the fools. (See our Strategic Investing department for more on why we think so.)

A successful buy-and-hold strategy, though, does require that you create a diversified portfolio. Unless you're saving for a retirement at least 30 years away, you can't just put 100% of your money in an S&P 500 index fund and expect it will be there when you need it. By the same token, you can't afford to go "safe" and stash your nest egg in a money-market fund. At a mere 3% annual rate of growth, you'll never make enough money to fund your golden years.

That's where a solid asset-allocation plan comes in — a structured program to balance your long-term investments between various types of stocks (or mutual funds), fixed-income investments and cash. Study after study has shown that portfolios invested in different kinds of assets perform better and are less risky than portfolios that are heavily weighted toward one type of asset. Some research, in fact, suggests that your investment results depend more on how your assets are allocated among stocks, bonds and cash than on the actual investments you choose.

The applet on this page lets you see how different mixes of assets produce different results in terms of return and volatility. Say, for instance, you had 54% of your money in three-month T-bills — practically the equivalent of cash — 18% each in 20-year bonds and large-cap stocks, and the rest in small-cap stocks. Over the years 1972 through 2006, you would've averaged an 8.8% return with 3.9% volatility. Not bad.

Now dial up the stock portion of your mix by moving the orange and brown dots so that T-bills make up just 20% of your portfolio, and bonds retreat to 12%. With 50% of your money in small caps, your average annual return over those 34 years sprouts to 11.7% and your best six months grows to a remarkable 42%. Your volatility rises significantly, too, but over that amount of time, you can certainly afford to wait out the declines.

What's the right mix for you? Our SmartMoney One Asset-Allocation worksheet will help you build a customized allocation based on just a few key variables: your age, income, net worth, spending needs, risk tolerance and expectations about the future. Generally speaking, the younger you are and the more money you have, the more you can afford the short-term volatility of stocks. But as you age — or if your spending needs increase — the more you'll need to protect your principal by shifting money toward bonds and cash.