Asset allocation describes the percentage of different types of investments inside your portfolio. Picking the right asset allocation depends on several factors, including your risk tolerance, time horizon and financial goals. Asset allocation models range from conservative to very aggressive.
What Is Asset Allocation and Why Is It Important?
Asset allocation is how you weigh stocks, bonds, cash and other investments inside your portfolio. It is an essential part of retirement planning and investing.
Asset allocation divides your investment portfolio by percentage into different asset classes. For example, you could have an asset allocation of 60 percent stocks, 25 percent bonds and 15 percent cash equivalent assets, such as certificates of deposit (CDs).
Asset allocation is important because it can help protect your portfolio against significant loss and keep you focused on your long-term investing goals.
Returns of stocks, bonds and cash tend to move in different directions at the same time. By investing in more than one asset class, you put yourself in a better position to counteract losses.
Asset allocation intertwines with diversification — another important investing concept.
You can think of asset allocation as laying the foundation for your portfolio’s structure.
Diversification builds on top of this by spreading investment risk among different subcategories within those asset classes.
It is possible to have excellent asset allocation but little diversification.
For example, imagine our example earlier, where your portfolio holds 60 percent stocks, 25 percent bonds and 15 percent cash equivalents.
If your stocks consist of shares from just one or two companies, you are not diversified. A diversified approach would select various stocks from different sectors and industries —such as technology, health care and energy.
Another way to achieve diversification is with mutual funds or exchange-traded funds (ETFs) that track broad indexes like the S&P 500 or different subcategories, such as growth, value and company size.
How To Determine the Best Asset Allocation for Your Situation
There’s no ideal one-size-fits-all asset allocation formula. Time, age and financial goals all play a role in finding the best mix of assets for your portfolio.
How you choose to invest your money, and the assets you hold, is a personal decision.
An effective asset allocation will likely change over time. It’s important to choose an allocation flexible enough to adapt to long-term trends in the market while meeting your own financial goals.
Diversifying your portfolio is not a one-time thing. Younger investors, for example, are often encouraged to put more money in stocks than bonds because more time in the market helps offset risk.
As an investor nears retirement, it’s common to shift a portfolio’s asset allocation toward bonds because there are fewer years of life left to recover from stock market downturns.
Of course, your risk tolerance also needs to be considered when deciding asset allocation, regardless of age.
Your time horizon is your length of investing time before you need to access those funds in the future. Time horizons can vary depending on your financial goals.
For example, if you are 30 years old and investing for retirement, your time horizon may be 35 years or more.
But if you are 30 years old and investing in your child’s college fund, your time horizon may be less than 15 years.
As you age, your time horizon shortens, regardless of your financial goal.
Risk tolerance is your comfort level and willingness to lose some or all your original investment in exchange for a potentially greater return.
Does the thought of losing money keep you up at night? If so, your risk tolerance is lower than someone more comfortable with uncertainty.
There is no right or wrong risk tolerance level – it is a psychological factor unique to each investor.
Online investment risk tolerance assessments can help you gauge your ability to handle loss. Some tools ask you about investment choices you made in the past, while others ask you to respond to hypothetical scenarios.
Examples of Asset Allocation Models
Many investment companies and robo-advisors use asset allocation models to simplify the process for clients.
Asset allocation can range from conservative to very aggressive.
Aggressive models hold more stock in their portfolio than moderate models. Similarly, moderate models have more stock than conservative ones.
Keep in mind that past performance does not guarantee future returns. Examples of asset allocation models below are for educational purposes only and are not intended to replace the advice of a certified financial professional.
A conservative asset allocation is composed of safer investments — such as cash and bonds — rather than stocks.
That’s because conservative investors either have a low risk tolerance, a short time horizon, or both.
Protecting your principal investment is the main purpose of a conservative portfolio — not huge gains. That’s why this type of allocation is also known as capital preservation.
If a conservative portfolio includes stocks, it tends to hold stable blue-chip companies or index funds. Both are less vulnerable to market swings than many other stock options.
A moderately conservative asset allocation exposes an investor to more stock, diversified primarily among large-cap domestic and international companies.
Fixed income securities, including bonds, still form the bulk of this asset allocation.
Some moderately conservative portfolios may also introduce a small real estate holding, usually through publicly traded real estate investment trusts (REITs).
Two moderately conservative portfolios offered by Comerica Banking list cumulative 1-year returns between 6 and 6.5 percent.
Comerica Banking’s moderately conservative model holds stock in large-cap companies like Amazon, Johnson & Johnson, Apple, Verizon and Facebook. It’s also diversified across several sectors, including health care, technology, industrials and financial services.
A moderately aggressive asset allocation shifts the focus from bonds to stocks.
This type of portfolio may be better suited for a young investor with a lower risk tolerance, or an older investor with a higher risk tolerance.
Moderately aggressive asset allocations are sometimes referred to as balanced portfolios because the mix of stocks and bonds aims to achieve a balance between growth and income.
The sole focus of an aggressive asset allocation is growth investing. Stocks make up most of this portfolio model.
Real estate holdings may be bigger. Exposure to small-cap companies and emerging markets often increases, as these holdings offer higher potential growth.
An aggressive investor has a high-risk tolerance and a long-time horizon. This person is comfortable and willing to lose money to get better results.
An aggressive asset allocation is not recommended for someone nearing retirement and needs to access their money soon. The price for potentially big gains is high volatility — especially in the short term.
A very aggressive asset allocation consists almost entirely of stocks. The goal is strong growth over a long time.
This asset allocation likely includes newer or small and emerging companies that can realize major gains and carry the risk for substantial losses in the short term.
These portfolios are ideal for a young investor who wants to build wealth over time.
A very aggressive portfolio could also dabble in alternative investments, such as cryptocurrency and mineral rights, depending on an investor’s risk tolerance.
7 Cited Research Articles
- Charles Schwab. (2021). Finding the Right Asset Allocation. Retrieved from https://www.schwabmoneywise.com/essentials/finding-the-right-asset-allocation
- Benz, C. (2020, November 11). An Aggressive Retirement Portfolio in 3 Buckets. Retrieved from https://www.morningstar.com/articles/845027/an-aggressive-retirement-portfolio-in-3-buckets
- Berger, R. and Curry, B. (2020, June 9). Basic Asset Allocation Models For Your Portfolio. Retrieved from https://www.forbes.com/advisor/retirement/asset-allocation-models/
- Ericson, C. (2019, November 12). What's the Difference Between Conservative and Aggressive Investing and Portfolios? Retrieved from https://www.acorns.com/money-basics/investing/conservative-vs-aggressive-investing-and-portfolios/
- Comerica Banking. (2018, March 31). Moderately Conservative Portfolio. Retrieved from https://products.fitrusts.com/products/fit-risk-based-series/moderately-conservative/
- University of Missouri. (n.d.). Investment Risk Tolerance Assessment. Retrieved from https://pfp.missouri.edu/research/investment-risk-tolerance-assessment/
- U.S. Securities and Exchange Commission. (n.d.). Asset Allocation. Retrieved from https://www.investor.gov/introduction-investing/getting-started/asset-allocation