A Beginner’s Guide to Portfolio Asset Allocation
Asset allocation is all about putting your money to work in a way that makes sense for you. In dividing your investments among stocks, bonds, and other assets, you can better manage risk while aiming for steady growth. A strong asset allocation strategy also helps smooth out the bumps when markets get rocky so you can stay focused on your long-term goals. This article discusses what asset allocation really means and how making the right choices in this regard can help you build a stronger, more resilient investment portfolio.
What is asset allocation?
At its core, asset allocation brings the old adage “Don’t put all your eggs in one basket” to life: referring to the process of divvying up an investment portfolio among asset classes (typically stocks, bonds, and cash/cash alternatives) to create a diversified portfolio well-suited to weather market storms and maximize growth potential.
Common asset classes
Why invest in different assets? It’s simple: each asset class boasts its own unique risk and return characteristics and (historically) reflects unique market movement (e.g., when stocks go up, bonds typically go down and vice versa). The following generalization speaks to characteristics of the three most common asset classes.
Stocks
Stocks (or equities) represent ownership in a company, this asset class historically seeing the highest returns of the three but having the greatest level of risk as stock prices are subject to market fluctuations influenced by numerous factors including economic conditions, company performance, and investor sentiment.
Different stock categories based on market capitalization (the total value of company shares) come with varying degrees of risk/return as well. Large-cap stocks, shares of well-established companies with large market capitalizations (exceeding $10 billion), tend to see more stable prices but may offer slower growth. Mid-cap stocks (with market capitalizations between $2 and $10 billion) belong to mid-sized companies with comparatively mild stability but also mild growth. Finally, small-cap stocks (market capitalizations below $2 billion) represent smaller companies that are often more volatile but have the potential for higher returns.
Bonds
Falling in the middle of the risk-spectrum pack are bonds, debt securities issued by governments, municipalities, and/or corporations. They offer periodic interest payments and the return of principal at maturity. Bond prices are influenced by interest rates (carrying market and interest rate risk) with increased credit risk accompanying higher-yield bonds as well—as issuers with lower credit ratings may default on payments.
Cash and cash equivalents
Extending to physical currency, bank deposits, and short-term, highly liquid investments, these are considered the least risky overall to provide safety and liquidity. Returns on cash and equivalents are generally lower, however.
Asset allocation beyond stocks, bonds, and cash equivalents
While stocks, bonds, and cash equivalents are the most common types of investments, plenty of other asset classes are also in play here including…
Real estate: Properties such as land, residential homes, commercial buildings, and rentals
Collectibles: Items that often appreciate in value over time including art, antiques, rare coins, and vintage cars
Cryptocurrencies: Digital or virtual currencies such as Bitcoin, Ethereum, etc.
Hedge funds: A limited partnership of investors that typically has more flexibility (than, say, a mutual fund) to invest more aggressively and ideally maximize returns
Derivatives: Contracts based on the value of an underlying asset, group of assets, or benchmark
Types of derivatives
Futures, whereby two parties agree to buy and sell an asset at a set price in the future; commodity producers (e.g., oil, gas, and agriculture companies) and consumers often utilize this option to lock in prices for goods or hedge against potential price fluctuations.
Forwards, similar to futures and traded over the counter (OTC) rather than on an exchange; OTC markets are less regulated as what’s essentially a lower-tier marketplace for smaller companies (public outfits aren’t often listed on exchanges).
Options, similar to futures and forwards but non-binding; the party buying the contract is under no obligation to use it, with these often used for stock speculating.
Swaps,which give two parties the ability to exchange cash flows/liabilities to help reduce costs or generate profits; these are often used for interest rates, currencies, and credit defaults (which gained notoriety during the 2007–2008 financial crisis).
Alternative assets and risk
So, how exactly do these less traditional assets fit into a portfolio? Should we consider them with respect to asset allocation? Moreover, are more asset classes always better? The short answer to the last question is no, not necessarily.
The goal of asset allocation is to diversify your portfolio to minimize risk and increase returns; one potential concern with alternative investments is their higher level of risk (e.g., cryptocurrencies are historically volatile). While their inclusion is perhaps appropriate for some investors, this is not the case for others. Liquidity is another potential concern; investing in many alternative investments means locking up your money—sometimes for years—which is both inconvenient and potentially riskier as it’s difficult to predict future markets, potentially putting you in a bind if you need access to your money.
If you already have a strong portfolio of stocks and bonds and believe additional diversification may be appropriate, however, it’s worth discussing this strategy with your financial advisor.
Risk tolerance and asset allocation
One large reason why no “perfect” asset allocation exists is because different investors have different risk tolerances (one’s ability and willingness to tolerate large swings in investment value); relatedly, different investors require their money at different times (i.e., their “time horizon”).
Example
Let’s consider two investors, one who’s 30 years old and investing for retirement (planned for age 65) with a 35-year time horizon and one who’s 59 years old and planning to retire within the next year at age 60. They both have an asset allocation of 75% stocks, 20% bonds, and 5% cash: considered a fairly risky portfolio given its high proportion of stocks.
Now, let’s say a recession suddenly hits. The jury’s out regarding how long it will take the market to recover, but what we do know is that it takes an average of 3.1 years for the stock market to bounce back and reach previous levels following a recession (based on numbers tracked since 1920). Let’s go with that.
In this case, our 30-year-old investor—who doesn’t need to draw from her investments for decades—is perfectly fine, her funds having plenty of time to recover and likely seeing many more recessions in the years ahead. Our almost-retiree, however is not so lucky; his portfolio takes a major hit, leaving him with less money for retirement than he had planned on and thus needing to work for two years additional years to make up for the difference.
Conservative vs. aggressive asset allocation: Which is right for you?
Perhaps you’re saying to yourself: Why didn’t he have a more conservative portfolio to limit risk? The most likely answer is he didn’t want to miss out on potential returns. Let’s consider another scenario with our same two investors, this time using an asset allocation of 20% stocks, 75% bonds, and 5% cash for both. Such an allocation is a highly conservative portfolio, allowing the almost-retiree to retire even if an imminent recession hits since he’d lose much less of his portfolio than he did earlier even if the stock market takes a nosedive. For our 30-year-old investor, however, this portfolio can mean missing out on a large sum of potential returns.
Long-term returns: the power of compounding
Historically, the S&P 500 has seen average annual returns of 10% while the average return on corporate bonds has hovered between 4% and 5% (per Smartasset.com). Three decades of compounding will only exacerbate this disparity and can mean the difference between retiring at age 65 as planned or enjoying the ability to retire early.
Rebalancing and asset allocation
When it comes to investing, one of two reasons typically triggers portfolio rebalancing: either the market causes an asset-allocation shift or your goals and risk tolerance change over time.
How market changes impact asset allocation
As time goes by, your portfolio’s asset allocation can drift away from what you originally planned—which is precisely why it’s important to rebalance, especially after big market swings. Imagine you start with a mix of 58% stocks, 38% bonds, and 4% cash, for example; while this setup might initially work well for your goals, you could end up with 70% stocks, 26% bonds, and 4% cash if stocks outperform bonds for a few years. Before you know it, your portfolio is suddenly riskier than you once intended.
How rebalancing gets you back on track
With your investment portfolio now carrying more risk than what you’re comfortable with, rebalancing enters the picture—tasking you with selling off some stocks and buying more bonds or cash to get back to your original asset allocation. Rebalancing helps keep your risk level in check and your long-term investing strategy on track.
When your goals change, so should your portfolio
Rebalancing isn’t just about reacting to the market, however, and is also tied to your own personal situation (as hinted at earlier). While you might be comfortable with more risk as someone in your twenties with retirement decades away, if your priorities shift—say, if you decide to buy a house a few years down the road—you’ll probably want less risk and more stable investments. That’s the perfect time to rebalance, tweaking your asset allocation to match your new financial goals and time horizon.
Key takeaway
Mastering the art and science of asset allocation is an excellent tool to help navigate the complexities of financial markets. By understanding your risk tolerance, embracing diversification, and committing to regular portfolio rebalancing, you can create and maintain an asset allocation designed to successfully optimize your portfolio.
Worried your portfolio might have too much risk? Enjoy the benefit of a complimentary portfolio review and risk assessment provided by one of our CFP® professionals.
FAQs
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Portfolio rebalancing frequency is influenced by various factors such as market conditions, investment goals, and risk tolerance. While some investors opt for an annual rebalancing, others choose a more dynamic approach. Either which way, regular assessment and adjustment are key to ensuring your portfolio stays aligned with your target allocation.
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Asset allocation is inherently personal, squashing any idea of a universal strategy. As tailoring your asset allocation to your individual risk tolerance, financial goals, and time horizon is paramount, what works best for one investor may not be suitable for another: emphasizing the need for a customized approach.
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As investors ride the wave of life, risk tolerance and financial goals fluctuate accordingly. Younger investors (with a longer time horizon) may adopt a more aggressive asset allocation with a higher percentage of stocks. As retirement beckons, however, it becomes prudent to shift to a more conservative allocation with a focus on income-generating assets.
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A common rule of thumb is the percentage of stocks in your portfolio should equal “100 minus your age,” with the remainder invested in lower-risk assets such as bonds. Investors in their mid-30s, for example, should allocate 65% of their portfolios to stocks. Nevertheless, such broad generalizations are sometimes not appropriate for plenty of reasons; an allocation of 25% stocks for a 25 year old and 75% stocks for a 60 year old makes little sense, for example.
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No investment strategy, including asset allocation, can guarantee profits. While this tactic effectively manages risk and optimizes returns, external factors and unforeseen events can impact portfolio performance nonetheless—speaking to the importance of regularly reviewing and adjusting one’s asset allocation based on evolving circumstances to boost the chance of sustained success.
About the author
The content in this post was developed by our team of writers and reviewed by our team of CFP® professionals here at Vision Retirement.
Retirement Planning | Advice | Investment Management
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Vision Retirement is an independent registered advisor (RIA) firm headquartered in Ridgewood, New Jersey. Launched in 2006 to better help people prepare for retirement and feel more confident in their decision-making, our firm’s mission is to provide clients with clarity and guidance so they can enjoy a comfortable and stress-free retirement. Schedule a no-obligation consultation with one of our financial advisors today!
Disclosures:
This document is a summary only and not intended to provide specific advice or recommendations for any individual or business. All investing involves risk, including loss of principal. No strategy assures success or protects against loss.
