What Is Asset Allocation?
Asset allocation may sound complex, but it’s actually a straightforward idea: It’s how you divide your money among different types of investments. Assets are your money and allocation is how you divvy it up.
Why are asset allocation choices a key piece of any investment plan? We’re so glad you asked. Investments vary in how risky they are. The highest-risk investments, such as stocks (aka equities), tend to offer the highest returns, while lower-risk investments, such as a savings account at a bank, offer lower returns.
Coming up with a plan for allocating your assets among different investment types entails deciding how much risk you’re willing to take on to get a higher return. Generally, a portion of your investment portfolio will go to stocks, a portion to bonds, and a portion to cash. (Often the cash portion isn’t counted as a piece of the pie in an investment asset allocation, but it’s not a bad idea to consider your cash reserves or emergency savings as a part of your overall asset allocation.)
Coming up with a plan for allocating your assets among different investment types means deciding how much risk you’re willing to take on to get a higher return.
An asset allocation example
There’s an old-school rule of thumb for asset allocation if the goal is retirement: Invest 100 minus your age in stocks (aka equities), and the balance in bonds (aka fixed income).
If you’re 30 years old, you’d invest 70% in stocks and 30% in bonds. Some might see this as a somewhat conservative asset allocation because, if the 30-year-old is investing for retirement, presumably they have more than three decades to ride out market volatility, and they might be better off with a higher portion of their portfolio in stocks — especially given that they’d be highly likely to earn a much higher return.
Still, if that 30-year-old has a low tolerance for risk, then a 70/30 portfolio for a long-term goal like retirement might be just the thing.
To figure out the best allocation for your own investment assets, consider two key questions:
- What’s your timeframe (aka time horizon) for this money?
- What’s your tolerance for risk?
Why your time horizon is important
Your timeframe or time horizon simply means: When are you going to need this money as cash in hand to purchase something, such as a house, car, college tuition, or to fund your retirement expenses?
If you’re not going to need your money for years or even decades (hello, retirement savings), then taking on stock market volatility is more feasible than if you need the money, say, next year.
For a long-term goal like retirement, you have plenty of time to ride out the market’s ups and downs, and once you get within a few years of needing to live on that money, you start moving it from the stock market into a less-volatile investment, such as short-term bonds or cash.
Or, say you want to save up for the down payment on a house and you want to buy that house in the next five years. Putting that money in the stock market is pretty risky — you may be forced to withdraw the money during a market downturn, meaning potentially you’d sell at a loss and end up with less money than you invested. Goodbye, new house.
For a short-term goal, it makes sense to allocate your assets to a safer investment, such as short-term bonds, a high-yield savings account, or a bank Certificate of Deposit, or CD. (As a general rule of thumb, money that you’re going to need in five years or less probably shouldn’t be invested in the stock market.) Of course, the tradeoff for lower volatility is a lower expected return.
Why your risk tolerance is important
Even if you have the exact same time horizon as your BFF, you each may choose a different asset allocation for your money. That’s because a person’s risk tolerance plays an important role in their asset allocation.
Say you’re saving for retirement. And say the thought of watching your investment account drop 30% in value freaks you the eff out — to the point where you’d be highly likely to sell all of your stocks in the middle of a market crash. Well, as you can guess, this is not a great situation to be in. It’s a money-losing situation, which is no fun at all.
The goal of understanding your tolerance for risk is to avoid situations where fear drives your investment decisions. You want, instead, to build a portfolio that you feel comfortable with — one where you accept some volatility in exchange for the opportunity to earn higher returns.
The goal of understanding your tolerance for risk is to avoid situations where fear drives your investment decisions.
If market swings give you heart palpitations, your own retirement-savings investment allocation should probably lean a bit more to the conservative side (think bonds) than someone who wants to be first in line to ride the market roller coaster (that person likes to jump in and buy when the market’s tanking because share prices are low), or someone who is able to focus on fun distractions when the market’s heading down (that person accepts market volatility in exchange for higher returns, and knows that as long as they don’t sell their shares during a dip, the losses are only on paper).
An important note about risk: There are many different types of risk. While we all know about stock market risk, even with an ultra-low-volatility investment such as a bank savings account, there is risk. Specifically, with bank savings accounts, there’s a very good chance that over time inflation will take a big bite out of your purchasing power. If your bank interest rate is 3% and inflation is 6%, over time your dollars are losing value. (And that situation is even likelier the lower your interest rate, so by all means stash your cash in a high-yield savings account.)
More asset allocation examples
There’s no one right way to allocate your own investment portfolio. And as we’ve been saying, your timeframe and risk tolerance will play big roles in your asset allocation decision.
But even though there’s no one right way to do this asset allocation thing, there are a ton of examples that you can use for inspiration (or just go right ahead and mimic them).
Keep in mind that, within each broad area of “stocks” and “bonds,” there are subsets of investments:
- The broad category of stocks can be broken down into domestic (U.S.) and international stocks (which in turn can be divided into emerging markets and developed markets); small-cap, mid-cap and large-cap stocks (capitalization refers to the total value of the company’s shares — it’s the value of one share multiplied by the number of outstanding shares); and more.
- The broad category of bonds can be broken down into U.S. Treasurys, municipal bonds and corporate bonds. Some corporate bonds are high-yield (they promise higher returns but have a higher risk of default), while others are investment-grade (considered much less risky).
Check out some model portfolios below from a couple of well-known U.S. brokers. As you can see for these particular portfolios, Schwab’s most aggressive allocation is invested 95% in equities (reminder: equity is another word for stock), while Fidelity’s most aggressive allocation is 100% in equities. On the most conservative end, Schwab’s portfolio is still 20% in equities, while Fidelity’s is 10%.
Important caveat: These companies’ portfolios are shown here somewhat out of context. Both companies offer a variety of model portfolios for different goals.
An example of Charles Schwab’s model portfolios
An example of Fidelity’s target allocation model portfolios
Your asset allocation: Next steps
Once you’ve decided on an asset allocation for your money, the next step is to find investments that match that allocation. Here are some ideas for doing that:
- Use a target-date fund. We talk a lot about these one-stop investment shops in our story on how to invest for retirement. TL;DR: they’re a super easy way to invest because they handle the asset allocation for you, including ongoing rebalancing (we talk more about rebalancing below).
- Build your own diversified portfolio. For most of us, this means buying index mutual funds and ETFs to match our desired asset allocation. You can do this either in a brokerage account that you open (here are our top picks for best brokers for beginners on sister site StockBrokers.com) or through your workplace retirement plan, like a 401(k). Then you divvy up your money among those investments. Check out our story on how to invest for retirement for more info on “lazy portfolios,” which can act as a guide to building your own portfolio.
- Build your own portfolio of stocks and bonds. Some people will want to create their portfolio with individual stocks and bonds. Scooch on over to our sister site, StockTrader.com, to get all the deets on how to trade stocks and bonds. Start with our stock trading education guide.
Keep in mind that asset allocation is a moving target, and things will change over time:
- As your investments rise and fall in value, their percentage allocation in your portfolio will get bumped up or down. It’s important to check up on your investments at least once a year to make sure your money is still allocated in the way you want, and, if it’s not, to rebalance.
- Rebalancing is shifting your money between investments to maintain your desired asset allocation over time. Here’s an example: Say you’ve set up a 90% stocks / 10% bonds (look at you, risk-taker!) investment portfolio, and over the past year the stock portion of your portfolio has been on a tear, growing wildly (yesssss!). As a result, the stock portion of your portfolio might have grown to 95%, and it might be time to sell some of those stock assets and put that money into fixed income. Or, you can rebalance by focusing your upcoming investment purchases into bonds, assuming you’re continuing to add new money to this portfolio.
- As you approach your goal, it’s important to reassess your asset allocation to see if you need to shift assets around to better suit your new time horizon. For example, if retirement is five years away, it’s probably time to sell some of your investments and move that money to cash. (Though, to be clear, retirement may last 30 years or more so it makes sense to keep some of your retirement portfolio invested for the long haul.)
Now, continue on in our series to learn about some key concepts that every investor should know.
Trading vs. Investing: What You Should Know
5 Investing Concepts Everyone Should Know