Asset Allocation

Asset allocation is the division of a portfolio among asset categories such as stocks, bonds and cash, in proportions that fit the investor's time horizon and risk tolerance.

How asset allocation works

The SEC's beginners' guide to asset allocation defines asset allocation as dividing an investment portfolio among different asset categories such as stocks, bonds and cash, and says the best mix depends largely on two factors: time horizon, the time until a financial goal, and risk tolerance, the ability and willingness to lose some or all of the original investment in exchange for greater potential returns. By the guide's account, stocks have had the greatest risk and highest returns, and large-company stocks have lost money about one year in three; bonds have generally been less volatile with more modest returns; cash equivalents have been the safest with the lowest returns, where the principal concern is inflation risk. Because the categories have historically not moved together, holding more than one has reduced the risk of loss.

Hypothetical example: an investor with a 30-year horizon chooses 80% stocks, 15% bonds and 5% cash; another two years from a home purchase chooses 20/30/50. See risk tolerance.

Why the allocation decision matters

The SEC guide reports that some financial experts consider the asset allocation decision more important than the choice of individual investments, because it sets overall exposure to risk and return. Too little risk and the portfolio may not grow enough to meet a long-term goal; too much and the money may not be there when a short-term goal arrives. The guide notes that most people investing for retirement hold less stock and more bonds and cash as they approach retirement age, and that allocations should change with a change in time horizon, not with recent asset-class performance. When markets move, the actual mix drifts from the target, which is addressed through rebalancing rather than by resetting the target. FINRA's asset allocation page likewise ties the mix to risk tolerance and horizon.

Hypothetical example: a 60/40 portfolio loses 18% if stocks fall 30% with bonds flat; at 80/20 it loses 24%, and at 40/60 it loses 12%. See the concentration calculator.