Asset Allocation: How to Do It and Why It Matters
Asset allocation spreads dollars across stocks, bonds, cash and other assets based on goals, age and risk tolerance.
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What is asset allocation?
Asset allocation is the distribution of a portfolio's assets into various asset classes, such as stocks, bonds, cash, real estate or alternative investments.
You may have heard the phrase “don’t put all your eggs in one basket.” In personal finance, those eggs represent your money, and the baskets are the various asset classes you can 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.
Types of asset classes
There is no universal list of asset classes. Asset classes are simply groups of similar investments. For example, some advisors may view asset classes by type of instrument, such as:
Cash
Stocks
Bonds
Real estate
Commodities
Derivatives
Private equity
Foreign currency
ETFs and mutual funds
Other advisors may describe assets classes by strategic goal, such as:
Growth
Value
Defensive
Income
Inflation protection
» Learn more. See the differences between stocks and bonds — and how they complement each other.
Why asset allocation is important
Asset allocation is important because the values of investments in different asset classes usually do not move together in tandem. For example, stocks and bonds typically move in opposite directions. When stock values decrease, bond values often increase.
By investing in different asset classes, an investor can guard against market volatility and gain flexibility, especially when liquidating investments to generate cash.
This is why changing your asset allocation can increase or decrease the risk in your portfolio and can increase or decrease how much your portfolio earns. Accordingly, asset allocation should reflect your goals, age and risk tolerance.
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 components work together to help you move more safely toward your destination.
Types of asset allocations
Portfolio asset allocations are characterized by their orientations.
An aggressive portfolio often has a high proportion of stocks and low proportion of bonds and cash.
A conservative portfolio often has a low proportion of stocks and high proportion of bonds and cash.
The calculator below lets you play with a few basic asset allocations. Note how asset allocations that are more heavily weighted toward stocks are riskier but have historically higher annualized returns (and more years resulting in a loss). Remember that past performance is not indicative of future returns.
How to choose the best asset allocation
The best asset allocation is the one that fits your specific goals, age and risk tolerance.
Asset allocation by goal
Consider what you’re investing for and when you need to fund that goal.
For example, if you’re saving for an event that will occur in the next five years, you probably don’t want to allocate much of those assets to stocks or bonds, which could lose value and not recover in time; cash or cash alternatives may be better.
If you're saving for an event that will occur in 15 or 20 years, you may want to allocate more assets toward riskier investments such as stocks, which could generate higher returns over time to help you reach your goal.
Asset allocation by age
Age often dictates asset allocation when saving for college and for retirement.
For college, an aggressive allocation may be appropriate for parents of toddlers, because graduation is more than 10 years away. Higher-risk, higher-return assets (such as stocks) may be optimal because short-term dips likely won’t disrupt the goal. As the child grows, however, the asset allocation should gradually become more conservative in order to protect the assets that will be needed soon.
For retirement in 20 or 30 years, allocating assets to stocks is a common approach because you have more time to weather market fluctuations. The primary focus is growing the money during that stretch. However, as you approach retirement age and prepare to leave the workforce, it may be appropriate to shift your asset allocation toward less risky assets.
You may not need to move your entire portfolio into bonds and cash on your retirement day. Retirement might last 30 years or more, and some of your money may need to continue to grow. Be sure to consult with a qualified financial advisor before making any big moves.
Asset allocation by risk tolerance
Risk is necessary for reward, but don't take on more than you can handle.
If your nest egg is larger than you need, you may be willing to take on more risk. You may be able to stomach losses more easily than someone with less to live on in retirement. Alternatively, you may prefer a conservative asset allocation in order to preserve what you have, since there's little need for your assets to grow further.
Asset allocation calculator
Use this calculator to determine where your portfolio allocation stands now.
How and when to allocate assets
Once you establish an overall portfolio allocation, you'll need to decide how to allocate the assets in each of your investment accounts.
Every account needn’t have the same allocation. For example, it can be sensible to be more aggressive in retirement accounts that have a long time horizon and be more conservative in taxable brokerage accounts that house funds you might need sooner.
Within each asset class, you likely want to diversify. This can also reduce risk without reducing potential returns.
For stocks, this might mean selecting a group of stocks that vary by geography, industry or market capitalization.
For bonds, diversification might mean selecting a group of bonds that vary by maturity, type of issuer or geography. You can even ladder bonds.
Your asset allocation should not be static.
Your needs will likely change over time. Review your portfolio periodically to ensure your asset allocation still make sense for your situation.
As the market moves, your asset allocation will shift by itself over time. For example, if the stock market is doing well and all of your stock investments are getting more valuable, stocks will be a larger percentage of the portfolio. When this happens, consider rebalancing your portfolio, which involves buying and selling assets in order to get your portfolio back in line with your ideal asset allocation.
If this seems like more effort than you want to make, there are some shortcuts.
Shortcuts to asset allocation
1. Ask a financial advisor to help
A financial advisor can evaluate your current financial situation, your goals and your risk tolerance to create an asset allocation that suits your needs. A financial advisor will also monitor your portfolio and work with you to revise your asset allocation as needed.
2. Use the rule of 100
To apply the rule of 100, subtract your age from 100 to determine the percentage of your portfolio that should be invested in stock. For example, the rule of 100 says a 40-year old should have 60% of their portfolio in stocks (100 minus 40 equals 60). Some advisors believe subtracting age from 110 or 120 is better. This approach may not be sufficient to meet your specific needs.
3. Invest in target-date funds
A target-date fund is a mutual fund that automatically rebalances over time, taking more risk early on and less as you get closer to your set goal. For example, if you plan to retire in 2050, you could choose a 2050 target-date fund, and it would automatically allocate and reallocate your assets over time with that year in mind.
4. Use a robo-advisor
A robo-advisor is an automated service that uses details about your time horizon, goals, and risk tolerance to algorithmically create a portfolio for you. They will automatically adjust your asset allocation over time, and many offer additional services.
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