Asset allocation

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 very 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.

While this may sound like a daunting task, there are straightforward guidelines to help in selecting an appropriate asset allocation.

Asset allocation strategies
There are three asset allocation strategies employed by investors.


 * Strategic asset allocation. Most investors following the Bogleheads® investment philosophy employ a strategic asset allocation policy, described below.
 * Tactical asset allocation. Tactical asset allocation shifts allocations according to economic or valuation factors.
 * Dynamic asset allocation. Dynamic asset allocation calls for allocations to shift in accordance with changing future liabilities, a condition especially relevant 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.

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.

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.

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, 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.

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.

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
Author Larry Swedroe has written a four-part guide for selecting asset allocation percentages; how much to invest in stocks versus bonds.

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:
 * 1) Investment horizon - when do you need the money?
 * 2) Stability of your earned income
 * 3) The need for liquidity - if you need the money in a hurry
 * 4) 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.

Rebalancing
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 to 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.

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.

Importance of asset allocation

 * Bogle, John C., The Riddle of Performance Attribution: Who's In Charge Here—Asset Allocation or Cost?, July 20, 1997
 * Ibbotson, Roger G., The Importance of Asset Allocation, Financial Analysts Journal Volume 66 Number 2, CFA Institute, 2010.
 * Sharpe, William F., Asset Allocation: Management Style and Performance Measurement, Reprinted from the Journal of Portfolio Management, Winter 1992, pp. 7-19. Viewed January 31, 2015.
 * The Vanguard Group, Sources of Portfolio Performance: The Enduring Importance of Asset Allocation, July 2003.

White papers

 * 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.

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).