When it comes to investing, there’s an old adage, “Don’t put all your eggs in one basket.” (Who carries their eggs in a basket anymore?) This is generally referred to as portfolio diversification.
The idea does make sense. Buying only one or two similar stocks might feel risky (and may be risky), no matter how profitable the companies currently are.
But did you know that diversification goes beyond the stock portfolio? For many investors, diversification might mean investing in other asset classes that don’t perform like stocks.
In fact, instead of considering which stock to buy, it may be more important to decide if it’s appropriate to own stocks in the first place. And, if it is appropriate, an investor may also want to ask: what proportion of a portfolio should be stocks?
Another way to describe the mix of stocks, bonds, cash, and other asset types in a portfolio? Asset allocation, or quite literally, the amount of money that is allocated to each of the different asset classes.
So what is asset allocation? Although it sounds like investing jargon, asset allocation is one of the more important investing concepts to understand. And although there is not a universal consensus about the right allocation mix for each investor, this big-picture decision could drive a majority of returns over time.
What Does Asset Allocation Mean?
Asset allocation is the investment strategy of balancing risk and reward by divvying up a portfolio into different asset types.
Generally, asset allocation is determined by looking at goals, risk tolerance, the investing timeline for the investor’s money, and comparing that to what the different asset classes have done over history. That way, an investor can determine what mix of assets is a good fit for what an investor is trying to accomplish.
Each asset class will have its own path of performance over time. The goal of diversification is to invest in such a way that not all investments perform the same or even similarly during different periods over the course of an investment journey.
For example, some investors may find it helpful to make investments beyond stocks during a stock market crash, which could have a sweeping and dramatic impact on all stock prices. Historically, bonds have performed well during stock market crashes, and aren’t considered to be correlated to stock market prices.
Therefore, bonds can act as a portfolio hedge during those stock market downturns. Another way to think about diversification? Stocks zig while bonds zag—or at least they have historically.
Using Modern Portfolio Theory
For all the statistics buffs out there, it may help to think of asset allocation in terms of Modern Portfolio Theory (MPT) . MPT assumes that investors are risk averse, and builds portfolios with the lowest level of risk given the desired level of return.
It does this by analyzing the historical return of each asset class, the variability of that return (called the variance), and the degree to which the price level of different asset classes experiences volatility at the same time (the correlation).
Within portfolios, volatility and risk are often measured by their standard deviation (which happens to be the square root of the variance).
For example, if there were two portfolios and both have the same expected rate of return, but one has a lower standard deviation, the investor may want to choose that one.
Managing Risk by Asset Class
Whether the goal is to try to minimize risk, maximize potential returns, or some combination of the two, a good place for an investor to start is to study the risk and return characteristics of the various asset classes, such as stocks, bonds, cash or money market funds, real estate, private equity, investment partnerships, and natural resources, like gold. Much of the time, the discussion about risk and reward of the different asset classes is focused only on the tradeoff between stocks and bonds.
Common stocks, also known as equities, historically fall on the higher risk and higher reward end of the spectrum. Bonds are often considered to be lower in risk but also lower in reward.
Cash and cash equivalents (like money market funds) are typically considered to be the safest options, in the sense that cash experiences little price volatility. But be aware: The value of cash is eroded by inflation over time, which means potentially losing purchasing power.
Not all stocks or bonds are the same. Categories within each of the asset classes may carry different risk and reward characteristics. For example, small cap stocks are typically considered to be riskier but may come with higher returns than large cap stocks (also known as big cap stocks), which are generally more established. This is because small cap stops have the ability to grow into large cap stocks, whereas large cap stocks may not experience as much volatility—in either direction.
That said, the difference between the two is somewhat subjective, and small cap stocks can be established (in other words, they’re not just start-ups), while large cap stocks can crash as well (think Enron). Within the category of bonds, for example, junk bonds may be riskier while U.S. Treasury bonds are considered a safer option.
Determining Asset Allocation
After learning what to expect from the different asset classes, a good next step is to think about goals, risk tolerance, and investing time horizon—for each pool of money to be invested. For example, an investor may want to invest retirement money differently than emergency money.
A couple questions an investor might begin by asking: What is their goal with this money? When will they need to use this money? The latter is the idea behind investing time horizon.
To determine an appropriate asset allocation, an investor may want to conceptualize how long this money needs to last or what amount is needed for a set goal. Last, they might consider asking: How much risk (volatility) are they comfortable with?
Recommended: age-based rule of thumb is to start with 100, subtract age, and the resulting number is the percentage to invest in stocks. (Or, simply invest current age in bonds, and the rest is allocated to the stock market.) So, for example, if someone is 30 years old, then this rule would have them invest in a portfolio of 70% stocks and 30% bonds.
Because people are living longer and healthier lives that require a longer-term focus on growth, this asset allocation model may be too conservative for some. Instead of 100, it might be more appropriate to use 110 or 120 .
Pro: This method for determining asset allocation is straightforward and may work for people in a straightforward financial situation that is typical for a person of their age group.
Con: These rules will not work for everyone. Investors can use this strategy as a guide, but may want to consider amending it based on some personal reflection regarding their current financial situation, financial goals, investing time horizon, and tolerance for risk.
Non Age-Based Asset Allocation Models
There are four general investment allocation models that may be used as guides for determining one’s asset allocation.
This model is for the investor who wants to preserve their capital. Said another way, it is an investment strategy for those who do not want to risk losing any money. Capital preservation is generally utilized by those with short-term goals.
Capital preservation may work for someone saving to buy a car in a year, or about to start a business, or building an emergency fund. (Emergency funds might not need to be used within a year, but the whole point is that they are available for use immediately in the event of an emergency.)
To deploy a capital preservation strategy, an investor would likely keep their entire portfolio in cash or cash equivalents, like a money market fund. Both stocks and bonds can lose money in the short term, and therefore may not be appropriate for an investor whose primary concern is not losing anything at all. If they are going to invest, they might consider investing in Treasury bills or certificates of deposit.
This investment model aims to do exactly what it sounds like: produce income for the investor. An investor targeting this allocation is likely to be living off of their investments in some capacity. This investor is choosing income over growth.
This strategy might be utilized by a person in retirement who needs their investment income to replace or serve as a supplement to their pension or retirement funds.
Such a portfolio will likely consist of investments that are known to produce income, but may be less likely to grow in value over time: bonds for large, profitable corporations and the U.S. government (often called treasury notes); Real Estate Investment Trusts (REITs); and shares of dividend-paying stocks, such as those of blue-chip (large) companies.
This is an investment model for those looking to target long-term growth in their portfolio—i.e. investors who are willing to take on additional risk, hopefully in exchange for higher returns. This portfolio is not necessarily geared toward income-producing assets, potentially because the investor is working and earning a livable salary and not looking to use their investment portfolio to produce income, or at least not yet.
This strategy could be used by a person who is early in their career, targeting growth for retirement, and who has a high risk tolerance.
A growth-oriented portfolio is typically invested, primarily or completely, in common stocks, whether via individual stocks, mutual funds, or exchange-traded funds.
A balanced asset allocation model is typically a blend of the income-producing and growth models. Such an allocation may make sense for a person nearing retirement or in the early stages of retirement.
A balanced strategy is also used by folks at all stages of their investment journeys because it can make sense from an emotional standpoint. The volatility of the stock market can be unnerving, and investors should take this risk seriously.
While the blend of investments will be different for each investor, a balanced portfolio is often invested in some combination of common stocks, medium-term, investment-grade bonds, and potentially REITs.
The idea behind a balanced portfolio is to strike a compromise between assets that grow over time and those that will experience smaller fluctuations while providing some income or growth in portfolios.
Pro: This method of determining asset allocation is closely tied to the actual goals and risk tolerance of a portfolio, which may be a more useful method than a generalized approach, such as an age-based method.
Con: This method does not directly address the fact that different pools of money may require a different allocation model and that these goals may change over time.
No matter which method of determining asset allocation chosen, it’s important to know that allocations can change over time. For many people, asset allocation may change when the goal for the money changes.
And it’s worth being careful when making changes based off of market behavior; an investor might put themselves at risk of making a detrimental change at the wrong time, like selling stocks at a low because they’re spooked.
Additionally, most asset allocations will require some amount of upkeep over time—this is called rebalancing. While research says it doesn’t matter if a person rebalances monthly, quarterly, or annually, checking too often can lead to loss.
That said, it’s probably a good idea to periodically check in and make sure that none of your asset classes has significantly outgrown its initial allocation size.
Once an investor’s determined asset allocation, the next step is to invest to fulfill those allocations. There are several options for this.
With funds, it is possible to be instantly diversified not only across different asset categories, but within the categories themselves. For example, one broad U.S.-stock ETF could be invested across multiple industries, or at various companies within one industry, or both.
Some investors may prefer to buy individual securities, such as stocks themselves. This method requires more work as the responsibility to research companies and diversify rests fully on the investor. But this may give the investor more control over the implementation of the strategy, which some people may prefer.
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Perhaps most importantly, because you don’t have to invest much money in individual stocks, that leaves more room for asset allocation—helping you to find and follow through on the investment strategy that’s right for you.
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Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.
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