How Asset Allocation Impacts Your Portfolio
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What is asset allocation?
Investing articles regularly contain some variation of the phrase “don’t put all your eggs in one basket.” Those eggs represent your money, and the baskets are the various asset classes you can choose to invest in. Deciding how many eggs (your dollars) go into each basket (the type of investment you choose, such as stocks or bonds) is called asset allocation.
Asset allocation plays a key role in the amount of risk you take with your investments, as well as in the investment returns received. When you pick an asset allocation, you spread your investable dollars across categories of investments, based upon your goals, age and risk tolerance. To get a better understanding of this, explore the historical performance of a few basic asset allocations below. (Note: Past performance is not indicative of future returns.)
Note how riskier allocations more heavily weighted toward stocks have historically higher annualized returns, but also have more years resulting in a loss.
What are the key asset classes?
Asset allocation is a big-picture view of your investment portfolio: Which asset classes do you want in your portfolio, and how much of your money do you want to put in each?
Asset classes are simply groups of similar investments. In a broad sense, the asset classes in question are stocks, bonds and cash (or cash equivalents like money market funds, certificates of deposit or savings accounts).
All of these asset classes bring something to your portfolio. Stocks generally offer the greatest potential for long-term growth but also may expose you to the greatest risk. Bonds can balance out risk from stocks and provide a steady stream of income. Cash bails you out of a jam when your roof fails or lets you meet short-term goals like a down payment on a home.
» Learn more. See the differences between stocks and bonds — and how they complement each other.
If a metaphor helps, think of asset allocation as a car: Stocks act as the engine, giving your portfolio power and forward momentum. Bonds are akin to shocks, absorbing impact and smoothing out bumps. And cash is like the brakes: the thing you use when you need to slow down or stop entirely. These different components work together to help you move more safely toward your destination.
Asset allocation is important because generally asset classes do not move together in tandem. By investing in different asset classes, an investor may guard against market volatility and gain flexibility, especially when liquidating investments to generate cash. For instance, stocks and bonds historically move in opposite directions. If the stock market is down, an investor who needs cash can sell bonds, allowing the stock market time to rebound before touching their stocks.
Often, you’ll hear a portfolio’s asset allocation characterized by its orientation. A more aggressive portfolio would have a higher allocation to stocks and lower allocation to bonds and cash, whereas a more conservative portfolio would have a lower allocation to stocks and higher allocation to bonds and cash.
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Choosing the best asset allocation
There’s no precisely right or wrong asset allocation, but you do want to settle on the best investment mix for your situation and needs — and by “needs,” we mean your goals, age and risk tolerance.
It’s usually not ideal to look at these needs in isolation as you shape your asset allocation strategy. Instead, consider them each in concert to make sure your approach fits both your goals and your time frame.
Asset allocation by goals
To get started, consider what you’re investing for and when you need to fund that goal. If you’re saving for a wedding in two years, you probably don’t want to put any of your money in stocks or bonds; you’ll instead heavily favor cash or cash alternatives. You don’t want to pull up to your wedding day to find that the market wiped out your catering budget.
A less defined goal, such as wanting to purchase a beach house in 15 or 20 years, would likely warrant more aggressive investing in hopes of growing your money quickly, making this goal less a dream and more a reality.
Asset allocation by age
Another way to look at your time horizon, or the length of time you have to invest before reaching your goal, is through age.
If you’re saving for a child’s college education, the child's age dictates the asset allocation. For a toddler, an aggressive allocation is appropriate since graduation is more than 10 years out — you may feel comfortable using higher-yielding assets (like stocks), since short-term dips likely won’t disrupt your goal. As the child grows, their allocation should gradually become more conservative as they near the time when they need to access these funds.
If you’re saving for retirement, you can look at your current age and your planned retirement age. If the latter is 30-some years away, for example, many advisors would say that the majority of your portfolio should be invested in stocks. You have more time to weather market fluctuations in that case, and your primary focus is growing your money during that stretch.
As you reach retirement age and prepare to leave the workforce, many advisors would suggest shifting toward a more conservative or less risky allocation. Contrary to popular belief, however, there’s no need to move your entire portfolio into bonds and cash on your retirement day. Remember, retirement isn’t the end — it’s a time period that might last 30 years or more. You need your money to continue to grow throughout those years, and that could mean maintaining a stock allocation.
» Planning for retirement? Read our guide on retirement investments
Asset allocation by risk tolerance
Another critical factor to consider is your risk tolerance. Risk is necessary for reward, but taking on more than you can handle can easily lead to rash reactions. You might be more prone to pulling out of the market every time you see a flash of red on CNBC, which means a company is trading lower. (You’ve no doubt heard that the goal is the opposite: Buy low, sell high.)
Risk tolerance can also depend on how your portfolio is tracking relative to your goals. If you’ve already saved a nest egg larger than you will ever need, you may be willing to take on more risk since you could stomach a potential loss more easily than someone who will have just enough to live on in retirement. Alternatively, someone with a large cushion may prefer to be very conservative to preserve what they have already since they have little need for their assets to grow further.
» Learn more: Bond ETFs
Asset allocation calculator
If you’d like to do asset allocation homework on your own, you’ll first need to determine where your portfolio allocation stands now. Our calculator below can help with this.
Shortcuts to asset allocation
Want to hop to it? There are tools that allow you to obtain a suitable asset allocation in one fell swoop.
Some investors follow the Rule of 100 to determine an asset allocation. This rule of thumb suggests subtracting your age from 100 to determine the level of stock exposure within your portfolio. For instance, a 40-year old should have 60% of stock exposure in their portfolio (100 minus 40 equals 60). However, given the increases in life expectancy over recent years, some advisors believe subtracting from 110 or 120 yields a more fitting measure today.
Another option is buying a target-date fund, a type of mutual fund that holds both stocks and bonds at a ratio designed to suit your time horizon. For example, if you plan to retire in 2050, you could choose a 2050 target-date fund, and it would automatically allocate your assets with that year in mind. It will also adjust your allocation over time, becoming more conservative as 2050 nears.
A drawback of both methods is that the allocation is the same for everyone based upon their age or time horizon, without consideration of their individual situation, other goals and risk tolerance. A robo-advisor, or computerized investment manager, will include those factors and then produce a portfolio that fits the bill.
Robo-advisors will also adjust your allocation over time, and many offer additional services, such as access to a human advisor. Most robo-advisors are less expensive than human investment managers, however, with many offerings beginning at 0.25% of the investor’s assets under management annually.
» Explore the top online advisors: See NerdWallet’s analysis of the best robo-advisors
Once you have an ideal overall portfolio allocation in mind, you can drill down into the asset allocation for each account. Every account needn’t have the same allocation. For example, it can be sensible to be more aggressive in retirement accounts that have a longer time horizon and more conservative in taxable brokerage accounts that house funds you might need before retirement.
After deciding the asset allocation within each account, you can tackle asset level diversification. Within each class you can choose stocks by geography, industry and market capitalization — a company’s size — or divide bonds by short- or long-term, type of issuer and geography. This is called diversification. You can even ladder bonds, buying a variety of maturity dates so you can move into a better rate if interest rates rise.
Diversifying within each asset class can help reduce your risk significantly without reducing your potential for returns. When you diversify, instead of buying one large-cap stock and calling that section of your asset allocation good, you might opt to buy a number of large-cap stocks or, perhaps better still, a large-cap mutual or index fund.
If this seems like more effort than you’d like to expend, consider the shortcuts above as potential alternatives.
» Lower your risk: Here’s more on how to diversify your portfolio
And remember, your portfolio’s asset allocation should not be static, because your needs will likely change over time. You’ll want to revisit your portfolio periodically to ensure that the asset allocation continues to make sense for your situation.
Also, as the market moves, your allocation will adjust over time. If the stock market is doing well, your allocation to stocks will likely grow and become a larger percentage of the portfolio. If this happens, you may consider rebalancing, or bringing your portfolio back in line with your ideal allocation.