Asset allocation is how investors divide their portfolios among different assets that might include equities, fixed-income assets, and cash and its equivalents. Investors ordinarily aim to balance risks and rewards based on financial goals, risk tolerance, and the investment horizon.
Key Takeaways
- Asset allocation is how investors split up their portfolios among different kinds of assets.
- The three main asset classes are equities, fixed income, and cash and cash equivalents.
- Each asset class has different risks and return potential, so each will behave differently over time.
- No simple formula can find the right asset allocation for every individual investor.
Why Is Asset Allocation Important?
There's no formula for the right asset allocation for everyone, but the consensus among most financial professionals is that asset allocation is one of the most important decisions investors make. Selecting individual securities within an asset class is done only after you decide how to divide your investments among stocks, bonds, and cash and cash equivalents. This will largely determine your investment results.
Investors use different asset allocations for distinct goals. Someone saving to buy a new car in the next year might invest those savings in a conservative mix of cash, certificates of deposit, and short-term bonds. However, individuals saving for retirement decades away typically invest most of their retirement accounts in stocks because they have a lot of time to ride out the market's short-term fluctuations.
Risk tolerance plays a key factor as well. Those uncomfortable investing in stocks may put theirmoney in a more conservative asset class despite having a long-term investment horizon.
Age-Based Asset Allocation
Financial advisors generally recommend holding stocks for five years or longer. Cash and money market accounts are appropriate for goals less than a year away. Bonds fall somewhere in between.
Financial advisors once recommended subtracting an investor's age from 100 to determine what percentage should be invested in stocks. A 40-year-old would, therefore, be 60% invested in stocks. Variations of this rule recommend subtracting age from 110 or 120, given that average life expectancy continues to grow. Portfolios should generally move to a more conservative asset allocation to help lower risk as individuals approach retirement.
Asset Allocation Through Life-Cycle Funds
Some asset-allocation mutual funds are known as life-cycle or target-date funds. They set out to provide investors with portfolios that address their age, risk appetite, and investment goals with the correlated parts of different asset classes. Critics of this approach point out that a standardized solution for allocating portfolio assets is wrongheaded because individual investors require individual solutions.
These funds gradually reduce the risk in their portfolios as they near the target date, cutting riskier stocks and adding safer bonds to preserve the nest egg. The Vanguard Target Retirement 2030 is an example of a target-date fund.
The Vanguard 2030 fund is for people expecting to retire just before or after 2030. As of Aug. 31, 2023, its portfolio comprises 63% stocks, 36% bonds, and 1% short-term reserves. This asset allocation was achieved by investing in the following four funds:
- Vanguard Total Stock Market Index Fund Institutional Plus Shares
- Vanguard Total Bond Market II Index Fund
- Vanguard Total International Stock Index Fund Investor Shares
- Vanguard Total International Bond II Index Fund
How Do Economic Changes Affect Asset Allocation Strategies?
Economic cycles of growth and contraction greatly affect how you should allocate your assets. During bull markets, investors ordinarily prefer growth-oriented assets like stocks to profit from better market conditions. Alternatively, during downturns or recessions, investors tend to shift toward more conservative investments like bonds or cash equivalents, which can help preserve capital.
What Is an Asset Allocation Fund?
An asset allocation fund provides investors with adiversifiedportfolio of investments across various asset classes. The asset allocation of the fund can be fixed or variable among a mix of asset classes. It may be held to fixed percentages of asset classes or allowed to lean further on some, depending on market conditions.
What Is a Good Asset Allocation?
What works for one person might not work for another. There is no such thing as a perfect asset allocation model. A good asset allocation varies by individual and can depend on various factors, including age, financial targets, and appetite for risk. Historically, an asset allocation of 60% stocks and 40% bonds was considered optimal. However, some professionals say this idea needs to be revised, particularly given the poorer performance of bonds in recent years, and say other asset classes should also be introduced to portfolios.
What Is the Best Asset Allocation Strategy for My Age?
Generally, the younger and further you are from needing to access the capital invested, the more you should invest in stocks. One common guideline that’s ordinarily quoted is that you should hold a percentage of stocks that is equal to 100 minus your age. So, if you are 30, 70% of your portfolio should supposedly consist of stocks. The rest would then be allocated to safer assets, such as bonds. But a lot of these rules don't work for everyone. For advice that reflects your personal circ*mstances, reach out to a financial advisor.
How Does Behavioral Finance View Asset Allocation?
Behavioral finance explores how common cognitive errors might influence our financial choices. For our asset allocation, we might be swayed too much by recent market trends, overconfidence, sunk-cost reasoning, or loss aversion, which can lead to less beneficial allocation choices. Awareness of these cognitive biases can help you keep a disciplined, long-term approach aligned with your goals.
The Bottom Line
Most financial professionals will tell you that asset allocation is one of the most important decisions investors can make. The selection of individual securities is secondary to how assets are allocated in stocks, bonds, and cash and cash equivalents, which will play more of a role in your investment results.
