What is asset allocation?

How does asset allocation work?

“Asset allocation is the mix of investments within someone’s portfolio,” said Michael Hunsberger, the owner of Next Mission Financial Planning. “Stocks, bonds, real estate, cash and alternative investments are different asset classes that, when looked at as a whole, form your asset allocation.”

Asset allocation is measured by viewing each holding in your overall portfolio as a percentage of your total investments. For example, you might hold 60% of your investments in stock index funds and 40% of your investments in bond index funds. This would be a classic 60/40 asset allocation.

In practice, coming up with an asset allocation for your investments requires considering a few factors, including:

• Risk tolerance: If you don’t like volatility, you’ll invest more in fixed income and safe assets. If you have a high risk tolerance, you might put more money into the stock market.
• Investing timeline: Your asset allocation is highly dependent on when you need access to those investments. For example, if you need the money within five years, you might allocate a larger portion toward safer funds, but if you have 30 years until retirement, you may allocate more toward the stock market.
• Financial goals: If you’re investing for retirement, you might create an asset allocation geared toward long-term growth. If you’re saving for a down payment, you may allocate a lot more toward your savings account.

Choosing the right asset allocation for your investment portfolio is a balance of risk and expected returns, and figuring out what you are investing toward.

Understanding asset classes

Choosing your asset allocation means dividing your investments among several asset classes. There are many asset classes to choose from, but here are the main ones:

Why asset allocation matters

Asset allocation is important for a few reasons:

• Risk management: Owning multiple investments in different asset classes can lower your risk. If one investment goes down in value, your other investments may not.
• Diversification: Diversifying is a smart investment strategy because you benefit from the growth of multiple types of assets while not putting all your eggs in one basket.
• Goal planning: As your risk tolerance and goals adjust, you can reallocate your investments and choose an asset allocation that fits your new goals.
• Volatility reduction: Spreading your investments among different asset classes can help lower the overall volatility of your investment portfolio. This is especially true if you hold opposing or uncorrelated assets within your portfolio.

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How to create an asset allocation strategy

“There are many ways to build an asset allocation strategy, but they all should include a review of asset classes you’d like to use, how much diversification you want to include and how much risk you’re willing to tolerate,” Hunsberger said.

Here’s how to create an asset allocation strategy:

1. Assess your personal risk tolerance. It’s important to understand how much risk you're willing to take before choosing what to invest in.
2. Review your investment horizon. How long are you investing for? Knowing this will inform what assets to buy.
3. Define your financial goals. Define what you plan on using the invested funds for. This will help you choose the right investments for your goals.
4. Choose your investments. Once you’ve defined your tolerance, goals and timeline, you can choose your investments. This may include investing across multiple asset classes to build a diversified portfolio.
5. Rebalance as needed. Once you’ve chosen your asset allocation and have started investing, it’s a good idea to keep an eye on your portfolio. If you start to have too much or too little in any one asset, you can rebalance your portfolio to get back to your target asset allocation.

Your asset allocation may change over time as you approach your goals and retirement. One rule of thumb to consider is owning your age in bonds. This means if you are 45 years old, you would own 45% of your asset allocation in bonds (or bond funds).

But as the average life expectancy grows, new variations of this rule may include subtracting your age from a higher number, such as 110 or 120, and investing that amount in stocks. So, if you are 45 years old, you would own only 25% to 35% in bonds.

Here are a few other considerations when choosing an asset allocation:

• Target-date funds: If you want to simplify your asset allocation, target-date funds offer a single fund that owns multiple assets inside of it. This may include stocks, bonds and cash equivalents. As you age, the target-date fund will slowly shift from aggressive to more conservative investments.
• Active vs. passive (index) investing: Active investing involves tracking your investment performance and buying/selling to try to beat the market. Passive investing involves owning index funds that own all the investments within a market index. Passive investing typically beats out active investing over a long period of time.
• Fees: Financial advisors may charge fees for managing your investments, certain mutual funds may charge an upfront fee to purchase them, and many funds have an expense ratio, which is an annual fee for owning the fund. In general, investing in low-fee funds and investments is a better strategy than high-fee funds.

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Asset allocation examples

Different types of investors will have different asset allocations. Here are a few examples.

Young investor, 25 years old

Younger investors have a longer timeline to retirement and typically a higher risk tolerance. As they are just getting started with investing, they don’t mind seeing the balance go up and down, and know their best approach is a more aggressive growth strategy.

Here’s an example asset allocation:

85% stocks

• 55% large-cap stocks
• 25% small-cap stocks
• 5% emerging market stocks

15% fixed income

• 10% bonds
• 5% cash

Middle-aged professional, 45 years old

Someone in their 40s has a shorter timeline to retirement and might have a moderate risk tolerance. They are in their high-earning years but might not enjoy the volatility of dumping all of their money in the stock market.

Here’s an example asset allocation:

65% stocks

• 35% large-cap stocks
• 20% mid-cap stocks
• 10% international stocks

35% fixed income

• 25% bonds
• 5% CDs
• 5% cash

Near retirement, 60 years old

As investors approach retirement, they are typically much more conservative in their investments. They are more focused on preservation of assets than accumulation. They don’t want to see their portfolio dump 50% just before retiring, so putting a large amount into the stock market is out of the question.

Here’s an example asset allocation:

45% stocks

• 35% large-cap stocks
• 10% international stocks

55% fixed income

• 30% bonds
• 10% U.S. Treasurys
• 15% cash

Bottom line

Asset allocation is an important part of investing, and you should take some time to consider your risk tolerance, goals and investment time horizon before choosing your investments. Your asset allocation may shift over time, but keeping your goals in mind will help inform you of what allocation to choose.