Asset allocation is the process of dividing an investment portfolio among different asset categories, such as stocks, bonds, and cash. This process of determining which mix of assets to hold in a portfolio is a personal one. The asset allocation that works best at any given stage in an investor's life will depend largely on the investment time horizon and on both the investor's financial capacity and emotional capacity to tolerate risk and to stay the course.[note 1]
While this may sound like a daunting task, there are straightforward guidelines to help in selecting an appropriate asset allocation.
- 1 Asset allocation strategies
- 2 Strategic asset allocation
- 3 Rules of thumb
- 4 Ability, willingness, and need
- 5 Rebalancing
- 6 Asset allocation portfolios
- 7 Asset allocation funds
- 8 Notes
- 9 See also
- 10 References
- 11 Further reading
- 12 External links
Asset allocation strategies
There are three asset allocation strategies employed by investors.
- Strategic asset allocation (described below) is used by investors following the Bogleheads® investment philosophy. Strategic asset allocation is designed for the long run. It may be changed due to life events, but it should not be changed due to market conditions.
- Tactical asset allocation. Tactical asset allocation shifts allocations according to economic or valuation factors. Vanguard has historically used tactical asset allocation for a limited number of its balanced funds.
- Dynamic asset allocation. Dynamic asset allocation calls for allocations to shift in accordance with changing future liabilities, a condition especially relevant, since changes in pension law, to institutional defined pension and institutional endowment portfolios.
Strategic asset allocation
With a strategic asset allocation policy an investor selects a base target allocation to a selection of different asset classes. The main asset classes are equities (stock), fixed-income (bonds) and cash. The allocation to these asset classes is periodically rebalanced back to the target allocation. Rebalancing is necessary because the three main asset classes - equities, fixed-income, and cash equivalents - have different levels of risk and return, so each will behave differently over time.
A key reason for devising an asset allocation strategy is to help an investor reduce the risk inherent in volatile equity asset classes that are expected to provide higher returns by combining these asset classes with more stable fixed-income assets. These balanced portfolios help reduce volatility and down-side risk, thus better enabling an investor to maintain a long term investment program (stay the course) without panic selling during bear markets.
In short, during the next 20 or 30 years, there will be a single, best allocation that in retrospect we will have wished we have owned. The only problem is that we haven't a clue what that portfolio will be. So, the safest course is to own as many asset classes as you can; that way you can be sure of avoiding the catastrophe of holding a portfolio concentrated in the worst ones.
— William J. Bernstein, The Four Pillars of Investing, pg 244, McGraw Hill
The first table below shows the returns of various stock/bond allocations from 2000 -2002. This period was marked by falling stock prices. The second table reflects the longer-term rewards investors hope to receive, assuming that the historical pattern of bond returns providing a premium return over inflation, and stock returns providing a premium over bond returns will be realized. The tables show why asset allocation is important. It determines an investor's future return, as well as the bear market burden of periodic losses that he or she will have to carry successfully to realize the returns.
|Cumulative return after inflation from 2000-to-2002 bear market|
|80% stock / 20% bond||-34.35%|
|70% stock / 30% bond||-25.81%|
|60% stock / 40% bond||-19.99%|
|50% stock / 50% bond||-13.87%|
|40% stock / 60% bond||-7.46%|
|30% stock / 70% bond||-0.74%|
|20% stock / 80% bond||+6.29%|
| Projected 10 year Cumulative return after inflation |
stock return 8% yearly, bond return 4.5% yearly, inflation 3% yearly
|80% stock / 20% bond||52%|
|70% stock / 30% bond||47%|
|60% stock / 40% bond||42%|
|50% stock / 50% bond||38%|
|40% stock / 60% bond||33%|
|30% stock / 70% bond||29%|
|20% stock / 80% bond||24%|
Rules of thumb
Although an investor's exact asset allocation should depend on the goals for the money, some rules of thumb exist to guide decisions.[note 2]
We have suggested as a fundamental guiding rule that the investor should never have less than 25% or more than 75% of his funds in common stocks, with a consequence inverse range of 75% to 25% in bonds. There is an implication here that the standard division should be an equal one, or 50-50, between the two major investment mediums.
— Ben Graham, The Intelligent Investor
John Bogle recommends "roughly your age in bonds"; for instance, at age 45, about 45% of the portfolio should be allocated to high-quality bonds. Bogle also suggests that, during the retirement distribution phase, investors include as a bond-like component of wealth and asset allocation the value of any future pension and Social Security payment expected to be received.[note 3]
Investors choosing to use less conservative guidelines should understand why they feel they have the need, ability, and willingness to take on the greater inherent risk.[note 4]
All age-based guidelines are predicated on the assumption that an individual's circumstances mirror the general population's. Individuals with different retirement ages (earlier or later), asset levels (those who have saved enough to fund their retirement fully with TIPS, or needs for the money (e.g. college savings) would be well-advised to consider what circumstances make their situation different and adjust their asset allocation accordingly.
Ability, willingness, and need
- An investor’s ability to take risk is determined by four factors:
- Investment horizon - when do you need the money?
- Stability of your earned income
- The need for liquidity - if you need the money in a hurry
- Options that can be exercised should your existing plan fail to meet your objectives
- Define your willingness to take risk. Do you have the fortitude and discipline to stick with your predetermined investment strategy when the going gets rough?
- The need to take risk is determined by the rate of return required to achieve financial objectives. The greater the rate of return needed to achieve one's financial objective, the more risks with equities one needs to take. A critical part of the process is differentiating between real needs and desires.
- How you should handle difficult choices among ability, willingness, and need to take risk.
Over time an individual's asset allocation may change from it's original position as a result of the difference in returns from the various asset classes. Rebalancing is the act of bringing the asset allocation in line with current investment policy. A typical recommendation is that an investor should review the portfolio asset allocation once a year, and if necessary, rebalance as specified in the investment policy. Rebalancing is often the most difficult part because it is counterintuitive, it requires one to sell a portion of an investment that went up, and buy more of what went down.
Asset allocation portfolios
Strategic asset allocation strategies range from simple to complex.
- John Bogle is a proponent of simple asset allocation portfolios. He frequently advises that most investors should allocate investment portfolios using two asset class index funds: a U.S. total market stock index fund, and a U.S. total bond market index fund.
- A widely held portfolio among Bogleheads® Forum members is the three fund portfolio allocating investments among a U.S. Total market stock market portfolio; a Total International stock market portfolio, and a U.S Total bond market portfolio. This portfolio is frequently expanded to include a fourth asset class, U.S. inflation-indexed bonds.
- Some strategic asset allocation plans add additional asset classes or sub-asset classes to the asset mix. For equity investments these additions can include value stock funds, real estate funds (U.S. and international), gold, and commodity futures funds. Fixed income additions to the asset class palette include U.S high yield bond funds, international developed market bond funds, and emerging market bond funds. In addition, depending on an investor's risk tolerance preferences or tax situation, bond market allocations can be restricted to U.S treasury bonds or investment grade municipal bonds.
Asset allocation funds
Asset-allocation mutual funds, also known as life-cycle, or target-date, funds, are an attempt to provide investors with portfolio structures that address an investor's age, risk appetite and investment objectives with an appropriate apportionment of asset classes. However, critics of this approach point out that arriving at a standardized solution for allocating portfolio assets is problematic because individual investors require individual solutions.
- The most important decision is to start saving early and take advantage of compounded interest. Delaying will require more funds to reach an investing goal than if funds had been saved early-on. See: Importance of saving early
- Rule of thumb: A principle with broad application that is not intended to be strictly accurate or reliable for every situation. (Reference: Wiki: Asset Allocation - Update "Age in Bonds"?, forum discussion, direct link to post.)
John C. Bogle elaborates his position, in the 2010 edition of Common Sense on Mutual Funds, pp.87-88:
"Long before the crash, I had fine-tuned my rule-of-thumb asset allocation model, centered at 50/50 for older investors in the distributions phase of their investment plan. Rather, I recommended -- as a crude starting point -- that an investor's bond position should be equal to his or her age. An investor age 65, then, would consider the propriety of a 65/35 bond/stock allocation. Clearly, such a rule must be adjusted to reflect an investor's objectives, risk tolerance, and overall financial position. (For example, pension and Social Security payments would be considered bondlike investments.) But the point is that as we age, we usually have (1) more wealth to protect, (2) less time to recoup severe losses, (3) greater need for income, and (4) perhaps an increased nervousness as markets jump around. All four of these factors suggest more bonds as we age."
"Age in bonds" and its variants, (age - 10) or (age - 20), are very general rules of thumb to be adjusted for the investor's circumstances; a key circumstance being the presence or absence of a pension, which would change ones willingness or need to take risk. Some Bogleheads do not add pensions and Social Security to their asset allocation of bond holdings. (Reference: Wiki: Asset Allocation - Update "Age in Bonds"?, forum discussion, direct link to post.)
- Ability relates to an investor's ability to withstand the ups and downs of the market without getting nervous and making changes to the asset allocation. Selling in the face of a decline is about the worst thing an investor can do. Here is a table offered by author Larry Swedroe, based on the 1970s bear market, showing the amount of decline for various stock/bond allocations:
Asset Allocation %
20/80 5% 30/70 10% 40/60 15% 50/50 20% 60/40 25% 70/30 30% 80/20 35% 90/10 40% 100/0 50%
For example, an investor would be willing to accept a loss of 35% in the portfolio if she held an allocation of (80% stocks / 20% bonds). This table is from the 1970's; performance during other time periods will have different results. The general idea is for investors to select an asset allocation they are comfortable with. Source: Investment Planning, forum discussion.
- There are additional articles in the series:
Part V: Asset Allocation guide: U.S. vs. international equity, CBS Moneywatch, March 4, 2014.
Determine the appropriate mix between domestic and international stocks. (This article is US focused.)
Part VI: Asset Allocation Guide: Value vs. growth, CBS Moneywatch, March 13, 2014.
Decide how much to invest between value and growth stocks. (This article is intended for experienced investors who wish to deviate from the total market approach.)
Part VII: Asset Allocation Guide: Small-cap vs. large-cap, CBS Moneywatch, March 18, 2014.
Decide how much to invest between small-cap and large-cap stocks. (This article is intended for experienced investors who wish to deviate from the total market approach.)
- Asset allocation in multiple accounts
- Asset Classes (category)
- Asset Classes (Bogleheads Investing Start-Up Kit)
- Asset Allocation (category)
- Asset Allocation (Holding Bonds) Is Essential (Bogleheads Investment Philosophy)
- Variations on Bogleheads® investing
- Lazy Portfolios
- Tactical asset allocation
- Beginners' Guide to Asset Allocation, Diversification, and Rebalancing, from the SEC; with modifications according to this forum post: Re: Wiki comments requested: The importance of asset allocat.
- Wiki comments requested: The importance of asset allocation, forum discussion.
- The Pension Protection Act Of 2006, Department of Labor, viewed 5 February 2015
- Glide path ALM: A dynamic allocation approach to derisking, A strategy primarily used by institutional pension funds having to match funding levels for future liabilities. See Sample investment policy statement XYZ Company Pension Plan, Vanguard, August, 2011 for an example of an IPS employing dynamic asset allocation.
- Strategic Asset Allocation - Definition of Strategic Asset Allocation on Investopedia - A portfolio strategy that involves periodically rebalancing the portfolio in order to maintain a long-term goal for asset allocation.
- Stock return from a Wilshire 5000 index fund; bond return from a Barclays Capital Aggregate Bond Index fund; inflation data from US Treasury Department.
- Input parameters use exactly the same return rate each year, with no variations, no variance, no co-variance. This is a simplified calculation for illustrative purpose only; actual returns will vary.
- Graham, Benjamin. The Intelligent Investor (2003 edition annotated by Jason Zweig ed.). Collins Business. p. 93. ISBN 978-0060555665.
- Swedroe, Larry, Asset Allocation Guide: How much risk should you take?, CBS Moneywatch, February 3, 2014.
- Swedroe, Larry, Asset Allocation Guide: What is your risk tolerance?, CBS Moneywatch, February 12, 2014.
- Swedroe, Larry, Asset Allocation Guide: How much risk do you need?, CBS Moneywatch, February 19, 2014.
- Swedroe, Larry, Asset Allocation Guide: Dealing with conflicting goals, CBS Moneywatch, February 25, 2014.
- Ferri, Richard A. (2010). All About Asset Allocation: The Easy Way to Get Started (Second ed.). McGraw-Hill, Inc. p. x. ISBN 978-0071700788.
- Bogle argues this position in his classic text, Common Sense on Mutual Funds, ISBN 978-0470138137
Importance of asset allocation
- Brinson, Gary P., L. Randolph Hood, and Gilbert L. Beebower. "Determinants of portfolio performance." Financial Analysts Journal (1986): 39-44.
- Brinson, Gary P., Brian D. Singer, and Gilbert L. Beebower. "Determinants of Portfolio Performance II: An Update." FINANCIAL ANALYSTS JOURNAL 500 (1991): 40.
- Sharpe, William F., Asset Allocation: Management Style and Performance Measurement, Reprinted from the Journal of Portfolio Management, Winter 1992, pp. 7-19.
- Bogle, John C., The Riddle of Performance Attribution: Who's In Charge Here—Asset Allocation or Cost?, July 20, 1997
- Bernstein, William J., The Brinson 93.6% Hoohah, or, The Fable of the Blind CFAs and the Portfolio, 1997
- Ibbotson, Roger G., and Paul D. Kaplan. "Does asset allocation policy explain 40, 90, or 100 percent of performance?." Financial Analysts Journal (2000): 26-33.
- The Vanguard Group, Sources of Portfolio Performance: The Enduring Importance of Asset Allocation, July 2003.
- Ibbotson, Roger G., The Importance of Asset Allocation, Financial Analsts Journal, Volume 66 • Number 2, March/April 2010, CFA Institute
- Xiong, James X., Ibbotson, Roger G., Idzorek, Thomas M. and Chen, Peng, The Equal Importance of Asset Allocation and Active Management, Financial Analysts Journal, Volume 66 • Number 2, March/April 2010, CFA Institute.
- The global case for strategic asset allocation, Vanguard, 7/31/12
- Asset allocation in a low-yield and volatile environment, Vanguard, 11/30/2011, viewed January 5, 2015.
- The asset allocation debate: Provocative questions, enduring realities, Vanguard, 2007 (reprint of 2006 article), viewed January 5, 2015.
- Time diversification and horizon-based asset allocations, Vanguard, 05/16/2008, viewed January 5, 2015.
- Recessions and balanced portfolio returns, Vanguard, 10/06/2011, viewed January 5, 2015.
- The theory and implications of expanding traditional portfolios, Vanguard, May 2012, viewed January 5, 2015.
- Sa-Aadu, Jarjisu, Shilling, James D. and Tiwari, Ashish, Portfolio Performance and Strategic Asset Allocation Across Different Economic Conditions, (March 12, 2006).
- Statman, Meir and Scheid, Jonathan, Correlation, Return Gaps and the Benefits of Diversification, (November 2007).