Choosing Asset Allocation for Your Investment Portfolio

Asset allocation refers to the mix of asset classes – stocks, bonds, cash equivalents – held in an investment portfolio. Selecting the right asset allocation aligned with your risk tolerance and goals is a key factor driving long-term returns. This guide examines how to evaluate and construct the optimal asset allocation strategy.

Asset Allocation Overview

Asset allocation involves dividing money between different broad categories of investments:

• Stocks – Represent ownership shares in companies. Higher risk but higher return potential.
• Bonds – Loans issued by governments or corporations paying interest. More conservative than stocks.
• Cash equivalents – Very safe, liquid investments like money market funds. Low return potential.

Combining these core asset classes in varying proportions creates a diverse portfolio. The percentages invested in each is your asset allocation.

Impact on Returns

Numerous studies have shown asset allocation alone accounts for over 90% of variance in portfolio returns over time. The specific investments selected make up a relatively small portion of total performance.

This highlights the overriding importance of constructing the right asset allocation aligned with financial objectives and risk tolerance rather than chasing individual stocks and tactical market calls.

Common Approaches

Several standard asset allocation frameworks provide sound starting points:

Age-Based

Age-based allocations tie portfolio risk levels to your stage of life:

• Younger investors – 80-100% stocks for growth
• Approaching retirement – Balance of 60% stocks, 30% bonds, 10% cash
• Retirees – 40% stocks, 50% bonds, 10% cash for income and stability

As you age, allocations gradually shift from aggressive to conservative.

Core and Satellite

This approach carves out a “core” strategic allocation (e.g. 60/40 stocks/bonds) further divided into passive index funds and ETFs. A “satellite” portion (10-30% of holdings) goes to tactical active managers attempting to outperform the market.

Bucket Strategy

Bucket strategies place investments into different accounts or “buckets” based on time horizon:

• Short-term – Cash for immediate needs
• Medium-term – Bonds for stability and income over next 5-10 years
• Long-term – Stocks for growth over 10+ years

This creates multiple pools of money for varied purposes.

Choosing Your Approach

Consider these factors when selecting an asset allocation strategy:

Investment Horizon

Time horizon until you need access to the money dictates risk capacity. Longer horizons favor stocks while short term investors need stable allocations.

Risk Tolerance

How much volatility can you stomach? Conservative investors need more bonds and cash to dampen bumps. Those comfortable with risk can take on more equities.

Financial Goals

Investing for retirement income favors inclusion of bonds for stability. Those focused purely on long-term growth can maintain all-stock allocations. Match asset types to your goals.

Available Funds

Smaller portfolios may need complete strategy in low-cost mutual funds. Larger sums can diversify across many vehicles from ETFs to individual stocks and alternatives.

Stock Allocation Guidelines

For the stock slice of your portfolio, consider these guidelines:

U.S. vs. International

Diversify across global markets with an approximation of world capitalization – 65% U.S., 35% international stocks. Tilts can be taken but avoid single country exposure.

Market Capitalization

Blend a mix of large cap, mid cap, and small cap stocks. Large caps provide stability while small caps offer growth potential. Avoid microcaps due to liquidity concerns.

Growth vs. Value

Growth stocks represent companies expected to rapidly expand. Value stocks trade at lower valuations than peers. Blending both provides balance through market cycles.

Sectors

Don’t overload on individual sectors like tech that can see periods of extreme volatility. Diversify across industries. Many broad index funds provide this automatically.

Bond Allocation Considerations

Managing risk and generating retirement income drive most bond allocation decisions:

Credit Quality

The higher the credit rating, the lower the risk of default. But higher quality bonds pay less. Blend investment-grade bonds with smaller tactical allocations to high-yield for income.

Maturity Dates

Bonds with longer maturities are more sensitive to interest rate changes but pay more. Ladder maturities across near-term, intermediate, and long-term.

Active vs. Passive

Passive bond index funds provide diversified exposure at low cost. Actively managed funds aim to outperform the market via security selection. Use a mix.

Municipal Bonds

“Munis” offer tax perks for those in high brackets but come with less liquidity. Keep muni exposure below 20-30% of the fixed income sleeve.

International Exposure

Up to 20% of bond allocation can go to international issues to diversify currency and geopolitical risks. Primarily invest in developed markets.

Implementation Approaches

Once your asset allocation is set, choose from vehicles like these to implement it:

Mutual Funds

Mutual funds offer built-in diversification across varieties like equity, bond, ETF funds. Select low-cost index funds or blended active and passive.

ETFs

Exchange-traded funds track benchmark indexes but trade intraday like stocks. Use for core strategic holdings and tactical shifts.

Individual Stocks

For experienced investors, individual stocks allow customization and concentrated bets. Keep single positions below 5% of portfolio value for risk management.

Robo-Advisors

Robo-advisors like Betterment automate asset allocation using ETFs aligned to your goals. Ideal for passive investors seeking hands-off convenience.

Rebalancing Strategy

Over time, asset allocations drift from targets as markets shift. Rebalancing trades assets from overweighted classes back to desired levels. This boosts long-term returns.

Common rebalancing approaches include:

• Annual or semi-annual rebalancing
• Threshold-based (e.g. 5% deviation triggers trade)
• Time-based (every 3-5 years rebalance)

Don’t rebalance too frequently or transaction costs add up. Quarterly or annual is sufficient for most.

Adjusting Your Allocation

Review your asset allocation at least annually or when life changes occur. Ask yourself:

• Does it still align with my risk capacity given personal circumstances?
• Have my financial goals shifted requiring a reallocation?
• Does recent performance indicate I need more or less equity exposure?

Tweak allocations incrementally as needed – dramatic shifts should be rare. Work with a financial advisor if you lack confidence determining appropriate long-term allocation targets.

Conclusion

Selecting the optimal asset allocation to match financial goals and risk tolerance is one of the most important components of investing success. Follow prudent allocation frameworks, diversify across and within asset classes, implement passively and actively, and rebalance regularly. Your long-term returns will benefit greatly from a tailored, optimized asset allocation strategy.