An investing primer on asset allocation.
Investing in stocks is one of the greatest ways to build long-term wealth available to ordinary Americans. Despite the long-term benefits, stock investing carries several risks that make it a bad idea to keep 100% of your money invested in stocks throughout your life. Not even Warren Buffett — arguably the greatest stock investor of our time — puts all his money into stocks.
That’s where asset allocation comes into play. This investment strategy aims to balance risk with reward by allocating a portion of an investor’s portfolio to less risky asset classes to offset the risk associated with more volatile assets such as common stocks.
This guide will help investors understand the importance of asset allocation and the factors that play the most crucial roles in determining the best mix of assets for each investor.
What does asset allocation mean, and why is it important?
Asset allocation is an investing strategy that divides an investment portfolio among various asset classes. This process creates a diverse mix of assets designed to offset riskier assets with less risky ones. Asset allocation is often deeply personal since it depends largely on an investor’s ability to tolerate risk and their investing time horizon.
Asset allocation is the primary driver of the volatility an investor encounters and the returns they earn. According to a Vanguard study, about 88% of an investor’s experience is tied to asset allocation if they have a diversified portfolio, not to the specific stocks they own in that portfolio.
In other words, investors with the same asset allocation generally had consistent experiences, even if they held different investments. That’s primarily due to the correlation between assets in the same class, meaning they typically move in the same direction. Given the importance of asset allocation, investors must find the right mix that aligns with their risk tolerance and investing time horizon.
Finding the right asset allocation mix
As an example, let’s take a look at two hypothetical investors. One is single, 25 years old, does not have kids, and has a stable career. The other is a married, recently retired 65-year-old.
The first investor has a long investing time horizon because they’re decades away from retirement. The other has a shorter one since they’re already there. The first hypothetical investor doesn’t have a family yet but has a steady job, so they can afford to take more investment risks. But the other will likely want to play it safe.
Their asset allocations will likely be quite different. The first investor can afford to keep a larger portion of their portfolio in riskier assets. The recent retiree, however, will probably want a greater percentage of their portfolio in less risky investments since they have less time to make up for any bad ones.
Types of assets
There are three primary investment asset classes: equities, cash and cash equivalents, and fixed income.
Equities. Equities give an investor an equity interest or ownership claim in a business. Equity investments include common stock, preferred stock, mutual funds, and exchange-traded funds (ETFs). These equity investments could generate dividend income or be non-dividend payers, such as growth stocks.
Cash and equivalents. Cash and equivalents include cash, savings accounts, money market accounts, and bank CDs.
Fixed income. Fixed-income investments are debt and debt-like investments in a company or government entity or a loan to an individual. These investments include corporate bonds, municipal bonds, and Treasury bonds. They can also be mortgage loans, bridge loans, personal loans, and other debt-like instruments with a fixed-rate income payment.
Additional investable assets. There are also other types of investable assets. These include real estate, such as rental properties, farmland, and commercial properties; commodities like gold, futures, and other financial derivatives, such as options; and cryptocurrencies.
Asset allocation
Portfolio diversification is one step investors take to reduce their risk of suffering a permanent loss or enduring extreme volatility. Asset allocation takes that a step further by introducing less risky assets with lower volatility, like fixed income.
For example, here’s how increasing an investor’s allocation to fixed income can affect their portfolio’s overall volatility and returns:
| Asset Allocation | Average Annual Return | Best Year | Worst Year | Years With a Loss |
|---|---|---|---|---|
| 100% stocks | 12.3% | 54.2% | -43.1% | 25 out of 96 |
| 80% stocks and 20% bonds | 11.1% | 45.4% | -34.9% | 24 out of 96 |
| 70% stocks and 30% bonds | 10.5% | 41.1% | -30.7% | 23 out of 96 |
| 60% stocks and 40% bonds | 9.9% | 36.7% | -26.6% | 22 out of 96 |
| 50% stocks and 50% bonds | 9.3% | 33.5% | -22.5% | 20 out of 96 |
| 40% stocks and 60% bonds | 8.7% | 35.9% | -18.4% | 19 out of 96 |
| 30% stocks and 70% bonds | 8.1% | 38.3% | -14.2% | 18 out of 96 |
| 20% stocks and 80% bonds | 7.5% | 40.7% | -10.1% | 16 out of 96 |
| 100% bonds | 6.3% | 45.5% | -8.1% | 20 out of 96 |
Single asset classes
As the table shows, a portfolio with 100% stocks delivered the highest average annual return compared to portfolios with some fixed-income allocation. It also produced the best overall year. However, this hypothetical portfolio also endured the most years with losses and the biggest one-year loss.
As investors increased their allocation to fixed income — bonds, in this case — they reduced their overall average annualized return. However, they also reduced risk, as shown by the lower loss in the worst year and fewer years with losses.
Higher allocations of bonds generated some bigger one-year returns compared to a more balanced portfolio. Meanwhile, a 100% bond allocation led to a greater number of years with losses than some of the more balanced portfolios.
A mix of asset classes
Adding other asset classes to a portfolio can further reduce its overall volatility while improving returns. For example, a traditionally balanced portfolio (60% stocks and 40% bonds) produced a 6.1% average annual return over the 10-year period that ended in 2022 — and that’s after a huge 16% drop in 2022.
This 60/40 portfolio may not go up as much on average as a portfolio with a higher percentage of equities. But it tends to be less volatile than a portfolio comprised entirely of stocks.
Adding a 10% allocation to private real estate while dropping the stock and fixed-income allocations to 55% and 35%, respectively, could yield higher returns with less volatility than a standard 60/40 portfolio.
According to information published by private real estate investing company Accordant, a portfolio with a 10% allocation in private real estate returned 8.2% annually, on average, with 8.8% volatility during the decade leading up to the end of the first quarter of 2023. That’s compared to annual returns of 7.9% and volatility of 9.8% for a portfolio of 60% stocks and 40% fixed income.
Asset allocation by risk tolerance
An investor’s risk tolerance — their ability and willingness to lose some or all of their investment in exchange for a higher return potential — is an essential factor when determining asset allocation. Given that mixing in different asset classes reduces a portfolio’s risk profile, investors with a lower risk tolerance (regardless of age) should consider allocating more to less risky assets, such as fixed income and cash.
They also might want to consider other asset classes with less correlation to the stock and bond markets, like real estate and commodities such as gold, to reduce their portfolio’s risk profile further. Conversely, investors with higher risk tolerances should weigh their asset allocation more toward equities like common stocks.
Risk tolerance can be a state of mind, as some people are more risk-averse than others. Life stage or future planning also plays a role in determining risk tolerance levels.
A young investor might have an extremely low tolerance for losses, leading them to allocate more to less risky assets. On the other hand, a more risk-tolerant investor might choose to reduce their exposure to stocks and increase their allocations to bonds and cash if they had a recent life change (got married, lost their job, or had a baby).
Similarly, it makes sense for an investor to shift their allocation to less risky assets if they plan to use a portion of their investments to fund a large future expenditure, like a house, a new business, or travel.
Asset allocation by age
Age is another factor investors should consider when setting their asset allocation strategy. For age-based asset allocation, younger investors should consider having a higher allocation to equities, while older investors nearing retirement should increase the fixed-income percentage of their portfolio.
There’s no one-size-fits-all asset allocation strategy
Asset allocation plays a vital role in an investor’s overall experience since there’s a lot of correlation among assets in the same class. However, there’s no standardized asset allocation strategy for all investors.
Investors must personalize their asset allocation to ensure they have the right mix of asset classes for their risk tolerance and age. Doing so will improve their investing experience by reducing their portfolio’s overall volatility while still producing acceptable returns.
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