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 with it several risks that make it a bad idea to keep 100% of your money invested in stocks throughout your entire life. Even Warren Buffett -- arguably the greatest stock investor of our time -- doesn't put 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 what factors play the most crucial roles in determining the best mix of assets for each investor.

A balance with a money back on one side and boxes with assets written on them on the other side.

Image source: Getty Images.

What does asset allocation mean and why is it important? 

Asset allocation is an investing strategy that divides an investment portfolio among different 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, 88% of an investor's experience is tied to asset allocation if they have a diversified portfolio, not 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 need to find the right mix that lines up with their risk tolerance and investing time horizon.

As an example, let's take a look at two hypothetical investors. One is single, 25 years old, with no kids and a stable career. The other is a married 65-year-old who recently retired.

The first investor has a long investing time horizon since they're decades away from retirement, while the other has a shorter one since they're already there. Meanwhile, because the first hypothetical investor doesn't have a family yet but has a steady job, they can afford to take more investment risks, while the other will likely want to play it safe.

Thus, their asset allocations will likely be quite different. The first investor can afford to keep a larger portion of their portfolio in riskier assets. Meanwhile, the recent retiree will probably want a greater percentage of their portfolio in less risky investments since they have less time to make up for any bad investments.

Types of assets

There are three primary investment asset classes: 

  1. Equities: Equities give an investor an equity interest or ownership claim in a business. Equity investments include common stock, preferred stockmutual funds, and exchange-traded funds (ETFs). These equity investments might generate dividend income or could be non-dividend payers such as growth stocks.
  2. Fixed income: Fixed-income investments are debt and debt-like investments in a company or government entity or a loan to an individual. Fixed-income investments include corporate bondsmunicipal 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.
  3. Cash and equivalents: Cash and equivalents include cash, savings accounts, money market accounts, and bank CDs.

In addition to those three main asset classes, there are several other types of investable assets. These include real estate (rental properties, farmland, and commercial real estate), 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 impact their portfolio's overall volatility and returns:

Asset allocation

Average annual return

Best year

Worst year

Years with a loss

100% stocks

10.2%

54.2%

-43.1%

25 out of 94

80% stocks and 20% bonds

9.7%

45.4%

-34.9%

24 out of 94

70% stocks and 30% bonds

9.4%

41.1%

-30.7%

23 out of 94

60% stocks and 40% bonds

9%

36.7%

-26.6%

22 out of 94

50% stocks and 50% bonds

8.6%

33.5%

-22.5%

20 out of 94

40% stocks and 60% bonds

8.1%

35.9%

-18.4%

19 out of 94

30% stocks and 70% bonds

7.7%

38.3%

-14.2%

18 out of 94

20% stocks and 80% bonds

7.1%

40.7%

-10.1%

16 out of 94

100% bonds

6%

45.5%

-8.1%

19 out of 94

Data source: Vanguard. Return data from 1926 to 2019.  

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 evidenced by the lower loss in the worst year and fewer years with losses. Higher allocations to 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 more balanced portfolios.

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) has produced an 8.15% average annual return over the past 30 years.

This portfolio had a standard deviation (a calculation of annualized volatility) of 10.68% and a Sharpe ratio (a risk assessment based on the volatility of a portfolio's returns to a risk-free asset like short-term Treasury bills) of 0.76.

However, adding 10% allocations to real estate and farmland while dropping the stock and fixed-income allocations to 48% and 32%, respectively, yielded a higher total return (8.46%) with less volatility (8.62% standard deviation) and less risk (0.98 Sharpe ratio) during that time frame.

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Image source: Getty Images.

Asset allocation by risk tolerance

An investor's risk tolerance, or 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 tolerance for risk (no matter their age) should consider having a higher allocation 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 further reduce their portfolio's risk profile. 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. Meanwhile, life stage or future planning also play a role in determining risk tolerance levels.

A young investor might have an extremely low tolerance for losses, leading them to have a higher allocation 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 buy a house, start a new business, or travel.  

Asset allocation by age

Age is another factor that 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 between assets in the same class. However, there's no standardized asset allocation strategy for all investors.

Instead, an investor needs to 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.