Asset allocation is the practice of investing across asset classes in a portfolio in order to balance the different potential risks and rewards. The three main asset classes are typically stocks, bonds, and cash.
Asset allocation is closely tied with portfolio diversification. Diversification means spreading one’s money across a range of assets. In a general sense, it’s like taking the age-old advice of not putting all your eggs in one basket. An investor can’t avoid risk entirely, but diversifying their investments can help mitigate the risk that one asset class poses.
In addition to stocks, bonds and cash, some investors also allocate money into real estate, a range of commodities, private-equity or hedge funds, as well as even cryptocurrencies. Determining what kind of asset allocation makes the most sense for you depends on personal goals, time horizon, and risk tolerance.
Here’s a deeper dive on how asset allocation works.
The most common assets you can invest in are:
• Stocks: Stocks can be volatile, with the market going up and down, but they can also offer a higher return than bonds over the long run.
• Bonds: Bonds, such as Treasuries or municipal bonds, can be lower risk because they’re backed by government entities, but they also offer lower returns. There are higher-yield corporate bonds, which have greater returns and risk, but also tend to be less volatile than stocks.
• Cash or cash equivalents :This includes money in savings accounts or money market accounts, as well as certificates of deposit or Treasury bills. Obviously, the returns on these are very low but they’re also very secure. The biggest concern with cash investments is if inflation outpaces the return, then you technically could be losing money (e.g. future purchasing power).
What Factors Determine Your Asset Allocation?
There are three basic factors that will affect your asset allocation — your goals, your risk tolerance, and your time horizon.
• Goals. Your goals may be short term, such as adopting a child, starting a business, or saving for a down payment on a house in the next year or two. Or they may be long term, like planning ahead for that child’s education or saving for your retirement.
• Risk tolerance. Your risk tolerance is how much volatility — or ups and downs in the market — you can tolerate. This factor is important to get right. If you take on more risk than you’re comfortable with, and the market starts to drop, you might panic and sell investments at an inopportune time.
• Time horizon. Finally, your time horizon is the amount of time you have to invest before you need to achieve your goal. This factor can help you determine how much risk you’re comfortable with and influence your portfolio allocation. For example, if you have a long horizon there is more time to ride out the ups and downs in the market, and as a result, your risk tolerance may be higher.
You can see how these three factors come together to determine your asset allocation. If you have a short-term financial goal and will need your money relatively quickly — for example, if you’re about to buy that house you’ve been saving for — your risk tolerance will likely be lower, as you don’t want a market downturn to take a bite out of your investments just when you need to cash them out.
On the other hand, if you have a greater tolerance for risk — and if you think you may need more money for a down payment — you may choose a more aggressive allocation (for instance, tilting toward stocks) — in the hope of seeing more growth.
What’s a Good Asset Allocation Strategy?
The best asset allocation to meet your financial goals depends on a number of factors, most importantly your timeframe and your risk tolerance. For example, if you’re very far away from retirement, then you may be able to handle more risk in your retirement portfolio. But if you’re investing for your teenage kids’ college education, then that’s a shorter time frame and you probably shouldn’t take as many risks.
Your risk tolerance will also affect how you react to ups and downs in the market. Multiple studies have correlated the frequency with which you check your portfolio to losses over time — the more you stress over it, the more likely you are to pull your money out when you should just wait and stick with it.
So if you’re going to be someone who worries about every little blip in your investment portfolio, then you might need less risky investments. No investment is without risk, but you can spread the risk out across different assets and asset classes. But in general, higher-risk investments often have higher returns.
The 100 Rule
A common rule of thumb is known as The 100 Rule: Subtract your age from 100 and that’s the percentage of your portfolio that should be invested in stocks. For example, if you’re 25, then the 100 rule would suggest that 75% of your portfolio be in stocks and 25% in safer investments, like bonds, Treasurys, cash or money market accounts.
Target date funds are funds that more or less follow this style of rule — automatically adjusting the make-up of stocks vs. bonds as you near your target retirement date.
However, there are some caveats to this rule of thumb — people are living longer, every person’s situation may be different, and this is really only an asset allocation suggestion for retirement, not other financial goals you might have. Some financial advisors have even adjusted it to “The 110 or 120 Rule” because of increases in life expectancy.
What Is Risk Tolerance–Based Asset Allocation?
Risk tolerance–based asset allocation involves shaping your portfolio based on the level of risk you’re most comfortable with. For example, if you fit into the aggressive investor risk tolerance profile, that means you may commit a larger share of your portfolio to stocks and other higher-risk investments.
On the other hand, you may have a smaller asset allocation to stocks if you lean more toward the conservative end of the spectrum. The style of investor you are will likely shift throughout your lifetime. As discussed above, different life stages bring new concerns and priorities to mind, and this will naturally change how you view your asset allocation.
One thing that’s important to understand when basing asset allocation on risk tolerance is how that aligns with your risk capacity. Your risk capacity is the amount of risk you must take to achieve your investment goals. This is important to understand for choosing assets based on risk tolerance to find the right portfolio allocation.
If you have a low risk tolerance, but a higher risk capacity is required to achieve the investment goals you’ve set, then you may be at risk of falling short of those goals.
Meanwhile, having a higher risk tolerance but a lower risk capacity could result in taking on more risk than you need to in order to achieve your investment goals. Finding the right balance between the two is key when using a risk tolerance based asset allocation strategy.
How to Rebalance Asset Allocation
The other factor to consider is when to rebalance your portfolio in order to stay in line with your asset allocation goals. Over time, the different assets in your portfolio have different returns, so the amount you have invested in each changes—one stock might have high enough returns that it grows and makes up a significant portion of your stock investments.
If, for example, you’re aiming for 70% in stocks and 30% in bonds, but your stock investments grow faster until they make up 80% of your portfolio, then it might be time to rebalance. Rebalancing just means adjusting your investments to return to your desired portfolio make-up and asset allocation.
There are many rebalancing strategies, but you can choose to rebalance at set times — monthly, quarterly, or annually — or when an asset changes a certain amount from your desired allocation (for example, if any one asset is more then 5% off your target make-up).
In order to rebalance, you simply sell the investments that are more than their target and buy the ones that have fallen under their target until each is back to the weight you want.
The effect of asset allocation has been studied over the years and while the findings varied, one thing has remained constant—how you allocate your money to different assets is vitally important in determining what kind of returns you see.
However, it’s more than just diversifying within each asset class—it’s also about diversifying your entire investment portfolio across asset classes and styles. In general, for instance, stocks are considered riskier than bonds—though there are also different kinds of bonds.
There are many different kinds of funds with different asset allocation, and a fund doesn’t guarantee diversification—especially if it’s a fund that invests in just one sector or market. That’s why it’s important to understand what you want out of your portfolio and find an asset allocation to meet your goals — which may require professional help.
SoFi Invest® offers Automated Investing for those who need help finding the right mix of assets in their portfolio. Investors who want to pick and choose stocks, ETFs and fractional shares themselves can take advantage of the Active Investing platform.
How often should I review and rebalance my asset allocation?
You can review and rebalance your portfolio and asset allocation at any time, but you may want to set regular check-ins, whether they’re quarterly, biannually, or annually. One general rule to consider is rebalancing your portfolio whenever an asset allocation changes by 5% or more.
What factors should I consider when determining my asset allocation?
There are three main factors that will affect your asset allocation. First are your goals and whether they’re short term like saving for a house, or long term like retirement. Second is your risk tolerance, or how many ups and downs in the market you can live with. Risk tolerance is important because you’ll want to take on only as much risk as you can tolerate. Otherwise, you might panic during a market downturn and sell investments at a loss. The third factor to consider for asset allocation is your time horizon, or the amount of time you have to invest before you need to achieve your goal. This factor can help you determine how much risk you’re comfortable with.
How can I assess my risk tolerance and align it with my asset allocation strategy?
With risk tolerance–based asset allocation, you shape your portfolio based on the level of risk you’re most comfortable with. That said, the type of investor you are will likely change through the decades. Different life stages come with new priorities, and those will influence how you view your asset allocation.
When you base your asset allocation on risk tolerance, it’s important to understand how it aligns with your risk capacity, or the amount of risk you must take to achieve your investment goals. For instance, if you have a low risk tolerance, but a higher risk capacity is required to achieve your investment goals, you might fall short of your goals. Finding the right balance between the two is critical when you’re using a risk tolerance based asset allocation strategy.
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