Investing > Asset Allocation Explained

Asset Allocation Explained

Learn how to properly allocate your investments across asset classes that can make or break your portfolio. 

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Updated June 14, 2022

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Do you know what to invest in?

That’s actually a deceptive question—it may appear simple, but it’s anything but simple. Sure, in general, you do know what to invest in—stocks, bonds, ETFs, and so on. But investing isn’t something that is approached “in general”—you need specifics. 🎯

It might help if we posed the question another way—do you know what to invest in, and how much to invest in what? That brings us closer to today’s topic—asset allocation.

Asset allocation is mostly what it says on the tin—how you allocate your investments across different asset classes. But it is also something that, while it may appear simple at first, has a lot of hidden depth to it.

Asset allocation is deeply tied to key concepts such as diversification, risk, and return. To make matters a bit more complex, there’s no one-size-fits-all solution here—the ideal asset allocation will depend on a lot of specific factors that apply to your situation.

We live in uncertain times. Even if you’ve gotten quite good at picking stocks, even that isn’t a guarantee that you won’t experience losses. Some are of the opinion that the Fed isn’t ready to handle inflation—and we’ve seen how easily recessions can happen.

The only thing that can help you weather the various stages of the market’s cycles is a portfolio whose assets are properly allocated. That isn’t an easy thing to accomplish, and you’ll need to do a lot of the legwork on your own—but, we’re going to offer a helping hand, and try to explain as much as we can as best we can so that you can have an easier time of it.

What you’ll learn
  • Definition of Asset Allocation
  • Ideal Asset Allocation
  • The Different Asset Classes
  • Popular Asset Allocation Strategies
  • Asset Allocation Tips
  • Conclusion
  • Asset Allocation: FAQs
  • Get Started with a Broker

What is Asset Allocation? 💰

As we’ve already discussed, asset allocation is really just a fancy way of saying “how much are you investing in different asset classes”. For example, let’s say that you invest 80% of your money in stocks, and 20% in bonds—that’s an 80/20 asset allocation. Sounds simple enough, right?

But there’s more to it than meets the eye. How you should allocate your assets depends on a couple of factors unique to each individual—your age, your goals, and your risk tolerance. And even then, when you figure out what asset allocation works for you, you’re still left with the difficult task of research stocks, ETFs, mutual funds, and so on, and picking the best ones.

And the work doesn’t stop there, either. Things are never static—particularly so in the world of investing. The price of securities constantly changes—so not only is the price of what you’re going to buy constantly in flux, the value of that which you already own is also constantly changing—meaning that you need to correct the eventual drift in your portfolio every once in a while.

This is called rebalancing, and it’s another really important concept. You’re going to have to take care of it manually (except if you decide to invest via a good robo advisor), and depending on your asset allocation of choice, you might have to do it pretty often.

Okay, that’s the groundwork, and now that we’ve laid it, we will move on to more concrete and specific things—actionable advice and tips that you can actually apply. But first, let’s delve a little deeper into the how and why of asset allocation.

Why Asset Allocation Matters 📑

Asset allocation is important because it is the bread-and-butter of risk management. It’s the way in which we approach diversification—the age-old wisdom of “don’t put all your eggs in one basket” applied to investing.

If you were to invest all your money into a single business, you’d obviously do terribly if it were to fail. The same logic applies on a wider scale—if all your money is tied up in stocks, and the stock market has a couple of bad years, you’re in for a rough time.

Traditional Portfolio
The typical “risk parity” portfolio only consists of bonds, stocks, and funds that include the two asset types.

To avoid this, you don’t invest all your money into a single asset class. In fact, some asset classes mirror each others’ performance—when one goes down, the other goes up. This is called correlation, and stock correlations in the post-COVID market are as unpredictable as ever—all the more reason to look at the wisdom of Modern Portfolio Theory.

Now, MPT got its author a Nobel prize—and although that is high praise, that doesn’t mean that MPT is without its flaws. However, the basics in how it approaches diversification still apply—to achieve a good result, you need a mix of high-risk, high-reward assets, and lower-risk assets to act as a counterbalance. On the whole, this both reduces risk and increases returns.

The specifics will depend on your age and goals—however, proper diversification is a must for all serious investors. If you’re serious about meeting your goals, you don’t want to leave anything to chance—and to build and maintain a good portfolio, you’ll need to know the ins and outs of asset allocation like the back of your hand.

How to Determine Your Ideal Asset Allocation

Okay—now that we’re finished with the abstract and theoretical, let’s move on to practical advice. Here are the steps every investor should take to determine their ideal asset allocation.

Your Goals and Expected Returns 🏆

What is it that you want to achieve? Some vague notion of success just won’t cut it—you need either a tangible goal, like a second property or enough money to retire, or an amount of profit that would satisfy you—in other words, expected returns.

Without this information, it’s hard to measure whether or not a portfolio is on track to achieve its goal in the desired timeframe. Once you know what you want to achieve and how fast you want to achieve it, you can begin weighing the options. 

Slow and steady wins the race with conservative asset allocations, but they offer small returns, while risky aggressive portfolios might get the same job done twice as fast—but they also have a higher chance of crashing and burning.

Your Age 🔞

Your age plays an important factor. No matter what other goals you might have, we all have to retire at some point. The closer you are to retirement, the more conservative your portfolio can be.

One, this reduces the risk of a few bad years erasing all the hard work and gains that have already been made. Second, riskier investments are the better choice when you have a longer timeframe to work with—put simply, you have more time to recoup your losses, and the market, in general, is profitable in the long term. The average return of the stock market is pretty decent—but that average can easily be undone in a few bad years.

Your Risk Tolerance 🤌

Even if you’re far from retirement, you might not be in a position to construct an aggressive, risky portfolio. Put simply, not everyone has a strong safety net—and investing in high-risk securities simply doesn’t make sense for some people.

Your risk tolerance will play a large role in determining what the ideal asset allocation for you is. The higher it is, the larger proportion of equities

Your Income and Job Security 🔒

The question of income and job security is tightly related to the question of risk tolerance. Although none of us have absolute job security, being in a high-paying field that is in demand allows you to rest a bit more easily—knowing that you can find a job quickly should you lose it allows you to invest in riskier assets.

Asset Classes 🔍

Now that we’ve talked about the factors that you should consider when determining your ideal asset allocation, let’s take a look at different asset classes themselves—how they generally perform, what they’re good for, and what they’re not so good for.

Stocks 📈

Stocks represent a share of ownership in a company. They’re the most well-known of all investment vehicles and are considered one of the riskier investments. Stocks can be traded in the short-term, or bought and sold on a longer timescale in what is known as buy and hold investing.

Stocks are one of the riskier asset classes—but they also offer high returns. They’re also very liquid, meaning that selling them at a moment’s notice usually isn’t hard to do, and can also net you a nice source of passive income via dividends. Good, reliable stocks usually fall into one of two categories—growth stocks and value stocks.

Funds 💳

Funds are usually bought and sold in the form of mutual funds and exchange-traded funds or ETFs. Funds operate as a basket of securities—essentially, when you buy a mutual fund or an ETF, you buy a portion of the value of the assets that are included in the fund.

How-Do-Mutual-Funds-Work
Mutual funds and ETFs work similarly, but ETFs are passively-managed and charge lower commissions.

Some funds cover entire sectors or industries, while others focus on specific areas, and others follow a certain index. Funds offer a simple way to diversify and are generally held to be less risky than individual securities or stocks.

Bonds 📜

Bonds and similar investments, such as treasury notes, are very safe and conservative investments—however, they offer lower returns. Bonds are a good counterbalance to riskier securities, and as you approach retirement age, your portfolio should skew ever more toward slow, safe assets like bonds.

However, the one thing to keep in mind with bonds is that they will likely barely keep pace with inflation in a high-inflation, low-interest-rate environment. That’s why it makes sense to diversify the safe aspect of your portfolio rather than relying solely on bonds to be your safety net.

Derivatives 📒

Derivatives are complex financial instruments—stuff like futures, options, and swaps. These are highly risky products, and seeing as how most of them operate on a shorter time frame, we’d actually counsel you to not even think about futures, options, and swaps when it comes to asset allocation.

Trading derivatives is a whole another ball game and a skill of its own. Unless you have years to master that skill and an extremely high tolerance for risk, trading derivatives shouldn’t concern you.

Gold and Precious Metals 🪙

Gold and precious metals are popular hedges against inflation and are considered safe investments. The price of gold tends to rise during times of recession, so it pays to devote a certain amount of your portfolio to it ahead of time—even so, gold shouldn’t represent a large percentage of your portfolio because of its limited growth potential when the stock markets are bullish.

Cryptocurrency ₿

Cryptocurrency is all the rage nowadays. And it isn’t difficult to see why—the promise of decentralized, digital currencies is full of potential. However, we’re still in the early stages of this new form of currency.

The fact of the matter is, crypto is still far too risky for most investors. Similar to derivatives, it is an arena of its own—it has its own rules and intricacies, so most investors shouldn’t plan on including a large percentage of crypto in their portfolios.

Popular Asset Allocation Strategies 🎬

There are numerous asset allocations possible—but more or less all of them are based upon one of the strategies that we’ll be discussing in this section. These are the most common rationales behind asset allocations—so it’s highly likely that the solution that will work for you is one of these strategies.

Life-cycle Funds Asset Allocation ⏳

Life-cycle funds are a popular investment vehicle for retirement planning. They’re also commonly referred to as age-based funds or target-date retirement funds. Let’s break it down—these funds pick a certain date in the future, and they start off pretty aggressive—meaning that they initially have a larger allocation in stocks. 

But as time goes on, the funds become more conservative—and the closer to the target date they get, the larger the proportion of bonds in the fund. The idea is simple—once the target date comes, you’re ready to retire.

Of course, you don’t have to use that money to retire—but target-date funds are one of the more popular ways of investing for retirement. However, this strategy is based on the premise that young investors are prepared to take on more risk—and that isn’t always true.

Pros

  • Assets allocated automatically
  • Diversification is guaranteed

Cons

  • Doesn’t factor in anything other than age
  • Slightly inflexible as a strategy

Strategic Asset Allocation 📚

Strategic asset allocation is a long-term strategy. The crux of it is as follows: you pick an asset allocation based upon all the usual factors (age, goals, risk tolerance, and expected returns), and you rebalance your portfolio after a long period of time—at least one year.

After a year or more has passed, you rebalance your portfolio in order to return it to the desired asset allocation. This makes strategic asset allocation similar to buy-and-hold investing—it also stems from the logic that the market is profitable and efficient in the long term and that short-term reactions are best avoided.

Pros

  • Doesn’t require too much micromanagement
  • Long timeframe makes it easier to recoup losses

Cons

  • Requires a long investment horizon
  • Can be nerve-wracking

Tactical Asset Allocation 🧮

Tactical asset allocation is an active strategy—it requires a hands-on approach and actively adjusting your portfolio. Once you’ve settled on an asset allocation that fits your criteria, you actively monitor market conditions—and adjust accordingly.

This is different from timing the market, however. This approach is a bit slower and more deliberate and deals with entire asset classes rather than specific equities. For example, if you think stocks are undervalued, you might shift more of your portfolio toward stocks, as you expect a price correction will occur.

Conversely, if you see signs that equities will drop in price, you might want to allocate more of your portfolio to bonds. This makes ETFs and mutual funds a particularly good fit for this strategy.

Pros

  • Possibility of great returns
  • Requires constant monitoring and attention

Cons

  • Requires micromanagement
  • Effectively utilizing trends is difficult

Constant-Weighting Asset Allocation ⚖️

The constant-weight asset allocation strategy also requires a hands-on approach and frequent rebalancing. With this strategy, if an asset increases in value, you sell it, and if it decreases in value, you buy it. Put in other words, buy low, sell high.

Although there is no one-size-fits-all answer to how often you should rebalance with this strategy, we’d caution against rebalancing too often, as it is likely to turn into a knee-jerk response that goes contrary to the lessons of trading psychology. A good rule of thumb to use is that you should rebalance your portfolio when any asset moves more than 5% from the value you purchased it at.

Pros

  • Simple to execute
  • Flexible with regard to rebalancing

Cons

  • Quite a hands-on strategy that requires constant attention
  • Requires a good deal of research

Dynamic Asset Allocation 🌊

Dynamic asset allocation is a strategy that works by exploiting current trends. The portfolio is adjusted and rebalanced as needed, and the rationale behind the strategy is that you get rid of asset classes that are performing badly, and invest more in those that are performing well.

This strategy allows you to make use of momentum, however, it requires frequent rebalancing, and the frequent buying and selling of securities—meaning that it can easily wind up costing you a lot in transaction fees.

Pros

  • Flexible
  • Possibility of great returns

Cons

  • Effectively utilizing trends is difficult
  • Transaction costs easily add up
  • Requires plenty of effort and time

Age-based Asset Allocation 🔢

Age-based asset allocations all begin with the same premise—the older the investor, the more risk-averse they are. This is a generalization, but it isn’t inaccurate—it generally holds true that the closer you are to retirement age, the more conservative your portfolio should be.

A lot of age-based asset allocation strategies are very simple and often rely on rules of thumb. Some strategies suggest that you should subtract 20 from your age, and the given number is the percentage of bonds your portfolio would have—so for example, a 50-year-old should have 30% invested in bonds.

How a bond works
Bonds oblige the lendee to pay the lender after a fixed period, making the profits of bonds very predictable and reliable.

Others prefer the “age in bonds” rule, where you dedicate a percentage of your portfolio to bonds that is equal to how old you are—the same 50-year-old in our previous example should have 50% of their portfolio invested in bonds under this rule.

Age-based asset allocation strategies are simple, but they fail to consider a lot of factors. You should always factor in age, but these approaches are far too simple for most investors.

Pros

  • Varied
  • Simple

Cons

  • Too one-dimensional
  • Works best in conjunction with other strategies

Risk-Tolerance-Based Asset Allocation ⚡

A risk tolerance-based strategy is quite simple—the more risk-averse you are, the more conservative your portfolio will be. The more conservative your portfolio, the bigger the allocation of fixed-income securities such as bonds and treasury bills.

For example, an investor that is highly averse to risk might opt for an asset allocation of 70% in fixed income securities and 30% in equities. This is probably going to offer low returns, but it will be a safe portfolio. On the other hand, an investor that has a much greater risk tolerance will opt for an allocation in which stocks and other equities play a much larger role.

Pros

  • Simple to implement
  • Infrequent rebalancing

Cons

  • Narrow focus on risk tolerance
  • Bond yields are low

Asset Allocation Tips for Modern Investors ✏️

We’ve covered the most popular asset allocation strategies—and while each one of them has its own specific quirks and attributes, some things hold true for all asset allocations. In this part of the guide, we’re going to go through a few simple, actionable tips that all investors can make use of—regardless of their asset allocation of choice.

Remember to Rebalance 🤹🏼

Rebalancing your portfolio is incredibly important—after all, if you find an asset allocation that works for you, it stands to reason that you’d like to maintain it. Rebalancing entails selling off some parts of your portfolio and shoring it up in other areas.

There’s a lot of debate as to how often you should rebalance. There’s no one-size-fits-all solution here, but we recommend checking on your portfolio quarterly—and rebalancing if your asset allocation changes more than 5% or if you feel a large change is about to occur in the economy.

Keep an Eye on Inflation 🕵️

Inflation is simply a fact of life most of the time—but if inflation outpaces its own average, this could be a sign of an incoming recession. More to the point, inflation itself has an effect on assets—bonds don’t perform well when inflation is high, particularly long-term bonds.

One exception to this is Treasury Inflation Protected Securities or TIPS—treasury bonds that are indexed to inflation. They’re a great way to invest in fixed-income securities in times of high inflation.

On the other hand, inflation might actually be good for some stocks—as long as it isn’t too dire. If a stock is undervalued, the economic conditions brought on by inflation can actually make it easier for a business to pay off debts and continue expanding—and undervalued stocks will then likely see a noticeable increase in price.

Keep Your Other Eye on Interest Rates 🧐

Interest rates have an effect on both equity securities and fixed-income securities. We’re currently in a low-interest-rate environment—this makes stock prices rise, and is generally beneficial for equity securities. On the other hand, this same phenomenon is harmful to fixed-income securities, such as bonds.

Now, just to be clear, even when interest rates are low, you still need bonds in your portfolio—but in times like these, investing in bonds is a bit more unappealing than usually. That is because yields are low due to low interest rates, and the price of bonds can be high because they are a hedge against a recession that can happen if interest rates go up..

Diversify 👁️

Diversification has to be the follow-up to asset allocation. If you put 60% of your portfolio in bonds, and 40% in stocks, you’d think that you have a relatively safe portfolio on your hands—but if all of your investments in stocks are in one company, you actually have an incredibly risky portfolio.

Diversification entails spreading your investments, particularly in stocks, across different industries and sectors. The specifics are up to you—but to quote oft-repeated wisdom, you don’t want to put all your eggs in one basket.

Make Sure That Your Fixed Income Is Varied 💵

No matter how much of your portfolio you decide to dedicate to fixed-income securities, they need to be varied or diversified. This means buying a mix of short-term, medium-term, and long-term bonds, and can also mean buying bonds with lower credit quality if it fits into your strategy.

Another thing to consider is investing in municipal bonds, seeing as how they provide a good source of tax-exempt income.

Consider Real Estate and Dividends 🏠

The easiest way to obtain a passive income is by investing in real estate or dividend-yielding stocks. If real estate is out of your price range, consider investing in real estate investment trusts—companies that own income-producing real estate and pay out a pretty penny in dividends. 

Dividend Process
Dividends are paid to investors in regular intervals and can be automatically reinvested for greater portfolio growth.

Dividend investing is another strategy to consider—in either case, a good source of passive income is always a welcome addition and is beneficial both when times are good and when recessions occur.

Invest in Foreign Markets 💸

We’ve already discussed diversification—and the same principle applies on a geographic scale. The same logic totally applies here as well—you don’t want all of your investments to be tied up to one national economy—even if the economy in question is the United States.

Consider investing in foreign markets. Foreign stocks can be a bit more difficult to research, and you’re less likely to be already familiar with their products—but investing in them can be a great way to reduce the overall risk of your portfolio.

Conclusion 💡

If you’ve made it to the end of this guide, congratulations—and thanks for sticking with us. Stuff like asset allocation can easily seem boring—but it is incredibly important, and can even become interesting once you get the hang of things.

Properly allocating the money you invest is paramount if you want to achieve your financial goals. You can’t leave important details like that to chance—and once you’ve mastered this topic, you stand a much better chance of coming out on top when all is said and done.

Asset Allocation: FAQs

  • What is an Asset Allocation Fund?

    Asset allocation funds are funds that are tailor-made to fit a certain asset allocation or to meet a specific goal in a predetermined time frame.

  • What is the Best Asset Allocation for Retirement?

    The specifics will depend greatly on your personal circumstances, but in general, the closer you are to retirement, the more conservative your portfolio should be.

  • What is the Safest Asset to Own?

    Bonds, treasury bills, precious metals, and real estate are generally considered to be highly safe investments.

  • What is the Riskiest Asset Class?

    Stocks are generally regarded as the riskiest asset class—although as of late, we also have to point out that cryptocurrency is also a high-risk asset class.

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