Every investor needs a strategy for asset allocation because there are so many kinds of investable assets. Investing in stocks is just one possibility.
To be clear, stocks are one of the greatest ways for ordinary Americans to build long-term wealth. But there are several risks when investing in stocks, making it a bad idea to keep 100% of your money invested only 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. A portion of an investor's portfolio is allocated to less risky asset classes, balancing the risk associated with more volatile assets, such as common stocks.
Asset
This guide will help investors understand the importance of asset allocation and the factors that play the most crucial roles in determining the best asset mix for each investor.
What is it?
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 because it depends largely on an investor's ability to tolerate risk, their investing time horizon, and their own financial goals.
How important is asset allocation? According to a 2012 Vanguard study, asset allocation is the most important factor when it comes to an investor's total experience -- their overall returns and the volatility of those returns. Surprisingly, the specific assets in a diversified portfolio (stock A versus stock B) don't matter as much. What matters more is how a portfolio is allocated among asset classes.
In other words, investors with the same asset allocation generally have the same experience, even if they hold different investments. That's primarily because assets in the same class are correlated. So, if it's a bull market for stocks, many stocks will do well.
This underscores the importance of asset allocation. Given its importance, investors must find the mix that best aligns with their risk tolerance, investing time horizon, and personal financial goals.
The right mix
Finding the right asset allocation mix
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 married, recently retired, and 65 years old.
The first investor has a long investing time horizon because retirement is decades away. The other investor has less time because they've already reached retirement. The first hypothetical investor doesn't have a family yet and has a steady job, so they can afford to take more investment risks. But the other investor will likely want to play it safe.
Their asset allocations will likely be quite different because their needs are 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 safer investments -- if something goes wrong, they have less time to make up for any investing mistakes.
Types of assets
Types of assets
There are three primary investment asset classes: equities, cash and cash equivalents, and fixed income. Some other assets fall outside of these main categories.
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 certificates of deposit (CDs).
Fixed income. Investors can earn fixed income from companies, government entities, or even individuals by investing in debt and debt-like instruments. 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.
Fixed Income
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; and futures and other financial derivatives, such as options, are also possibilities. In recent years, investable assets have expanded to include cryptocurrencies.
Asset allocation
Asset allocation
Portfolio diversification is one step investors take to reduce their risk of suffering permanent loss or enduring extreme volatility. Asset allocation takes that a step further by introducing safer asset classes 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 |
|---|---|---|---|
| 100% stocks | 10.2% | 54.2% | -43.1% |
| 80% stocks and 20% bonds | 9.5% | 45.4% | -34.9% |
| 70% stocks and 30% bonds | 9.1% | 41.1% | -30.7% |
| 60% stocks and 40% bonds | 8.6% | 36.7% | -26.6% |
| 50% stocks and 50% bonds | 8.1% | 32.3% | -22.5% |
| 40% stocks and 60% bonds | 7.6% | 27.9% | -18.4% |
| 30% stocks and 70% bonds | 7.0% | 28.4% | -15.0% |
| 20% stocks and 80% bonds | 6.4% | 29.8% | -14.4% |
| 100% bonds | 5.1% | 32.6% | -13.1% |
As the table shows, a portfolio with 100% stocks delivered the highest average annual return. Portfolios with some fixed-income allocation had lower annual returns by comparison. A 100% stock allocation also produced the best overall year. However, this hypothetical portfolio endured the biggest one-year loss.
As investors increased their allocation to fixed income -- bonds, in this case -- they reduced their overall average annualized return, which might not sound appealing. However, they also reduced risk, as shown by the lower loss in the worst year.
Vanguard's research also shows that a portfolio more heavily weighted toward stocks produces more down years overall. From 1926 through 2022, a portfolio of 80% stocks and 20% bonds was down in 24 out of 97 years. By comparison, a portfolio that was 20% stocks and 80% bonds was down in only 14 of those years.
A mix of asset classes
An asset allocation strategy serves to reduce volatility in returns and mitigate some of the potential downside. To further put things into perspective, 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 increase as much on average as a portfolio with a higher percentage of equities. However, it tends to be less volatile than a portfolio comprised entirely of stocks.
The volatility further decreases, and returns can improve by diversifying into more asset classes. For example, investors could modify a traditional 60/40 portfolio by adding a 10% allocation to private real estate, which would drop the stock and fixed-income allocations to 55% and 35%, respectively.
According to information published by private real estate investing company Accordant, a portfolio with a 10% allocation in private real estate returned an average of 8.2% annually, 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.
By risk tolerance
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) can be dictated by their personality, future goals, or current life situations.
Risk tolerance isn't necessarily static. For example, an investor's risk aversion can change after a major life event, such as getting married, losing a job, or having a baby. Similarly, it makes sense for an investor to shift their allocation to safer 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.
However, regardless of the threshold or the reason, investors need to know their risk tolerance so that they can determine their asset allocation.
Investors with a lower risk tolerance should consider allocating more money to safer assets, such as fixed income and cash. Mixing in these different asset classes reduces a portfolio's risk profile and provides more peace of mind to risk-averse investors. And age isn't necessarily a factor here. Even a young investor can have a low tolerance for risk and choose to allocate to these safer assets.
Further mixing in other asset classes can reduce a portfolio's risk even more because other asset classes -- such as real estate or gold -- are less correlated to the stock market and bond market. Conversely, investors with higher risk tolerances should weigh their asset allocation more toward equities, like common stocks.
By age
Asset allocation by age
Age isn't necessarily a factor in determining risk tolerance -- high-risk and low-risk investors can be any age. But age should absolutely be a consideration for investors when setting their asset allocation strategy.
For age-based asset allocation, the long-term data supports younger investors having a higher allocation to equities because they generally have more time to invest. By contrast, older investors nearing retirement should increase the fixed-income percentage of their portfolio.
Related investing topics
Strategy
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 producing acceptable returns.
