Asset allocation

Asset allocation is an investment strategy that aims to balance risk and reward 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.
 * Strategic asset allocation
 * Tactical asset allocation
 * Dynamic asset allocation

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, fixed-income 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.

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.

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.

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.

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.