Asset allocation is an investment strategy that aims to balance risk and return by apportioning a portfolio's assets according to an individual's goals, risk tolerance and investment horizon. There are three asset allocation strategies employed by investors.
Most investors following the Bogleheads® investment philosophy employ a strategic asset allocation policy. This article discusses strategic asset allocation.
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.
There is no simple formula that can find the right asset allocation for every individual. However, the consensus among most financial professionals is that asset allocation is one of the most important decisions that investors can make. In other words, your selection of individual securities is secondary to the way you allocate your investment in stocks, bonds, and cash and equivalents, which will be the principal determinants of your investment results.
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.
|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%|
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.
Rules of thumb
Although your exact asset allocation should depend on your goals for the money, some rules of thumb exist to guide your decision.[footnotes 1]
The most important asset allocation decision is the split between risky and non-risky assets. This is most often referred to as the stock/bond split. Benjamin Graham's timeless advice was:
- "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."
John Bogle recommends "roughly your age in bonds"; for instance, if you are 45, 45% of your portfolio should be in high-quality bonds. Bogle also suggests that, during the retirement distribution phase, you include as a bond-like component of your wealth and asset allocation the value of any future pension and Social Security payment you expect to receive.[footnotes 2]
Investors choosing to increase their equity proportion, either through less conservative guidelines or a desire to increase return, should understand why they feel they have the need, ability, and willingness to take on the greater inherent risk.[footnotes 3]
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
Part 1: Asset Allocation Guide: How much risk should you take?, CBS Moneywatch, February 3, 2014.
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
Part II: Asset Allocation Guide: What is your risk tolerance?, CBS Moneywatch, February 12, 2014.
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?
Part III: Asset Allocation Guide: How much risk do you need?, CBS Moneywatch, February 19, 2014.
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.
Part IV: Asset Allocation Guide: Dealing with conflicting goals, CBS Moneywatch, February 25, 2014.
How you should handle difficult choices among ability, willingness, and need to take risk.
Over time your 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 you should rebalance at least once a year.
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.
Three fund portfolio
Ferri Core four portfolio
Schultheis Coffeehouse portfolio
Armstrong Ideal Index portfolio
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.
- 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
- 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 your ability to withstand the ups and downs of the market without getting nervous and making changes to your asset allocation. Selling in the face of a decline is about the worst thing you 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, you would be willing to accept a loss of 35% in your portfolio if you 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 to select an asset allocation you are comfortable with. Source: Investment Planning, forum discussion.
- There are three 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.)
- Definition of Asset Allocation, investopedia
- A dynamic investment policy that intuitively adapts to DB funding objectives, A strategy primarily used by institutional pension funds having to match funding levels for future liabilities. See Sample investment policy statement for a pension plan, Vanguard | 11/30/2009 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 are for illustration purpose only; actual returns will vary.
- Benjamin Graham, wikipedia
- The Intelligent Investor, p. 93 of the 2003 edition annotated by Jason Zweig, Collins Business, ISBN 978-0060555665
- Bogle argues this position in his classic text, Common Sense on Mutual Funds, ISBN 978-0470138137
- The global case for strategic asset allocation, Vanguard, 7/31/12
- Asset allocation in a low-yield and volatile environment, Vanguard, 11/30/2011
- The asset allocation debate: Provocative questions, enduring realities, Vanguard, 06/09/2005
- The influence of time diversification on horizon-based asset allocations, Vanguard, 05/16/2008
- Recessions and balanced portfolio returns, Vanguard, 10/06/2011
- The theory and implications of expanding traditional portfolios, Vanguard, 12/20/2007
- Academic papers
- 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).