Asset allocation is how you divide your portfolio among different asset classes: stocks, bonds, cash, real estate, and alternatives. Research shows it’s the most important investment decision you’ll make.
Beginner
What It Means
Asset allocation is your portfolio’s recipe - how much of each ingredient (asset class) to include. It determines your risk level and expected return more than any other decision.
Common Allocations
| Profile | Stocks | Bonds | Cash | Risk Level |
|---|
| Aggressive | 90% | 10% | 0% | High |
| Growth | 80% | 20% | 0% | Moderate-High |
| Balanced | 60% | 40% | 0% | Moderate |
| Conservative | 40% | 50% | 10% | Low-Moderate |
| Preservation | 20% | 60% | 20% | Low |
The 60/40 Portfolio
The classic “balanced” portfolio: 60% stocks, 40% bonds. It’s a common starting point that balances growth potential with stability.
Why It Matters
Research shows asset allocation explains about 90% of portfolio return variability over time. Individual stock selection matters far less than your mix of stocks vs. bonds vs. other assets.
Advanced
The 90% Rule
Brinson, Hood, and Beebower (1986) found that asset allocation explains over 90% of the variation in portfolio returns over time. This landmark study shifted focus from stock picking to strategic allocation.
This doesn’t mean 90% of returns come from allocation - it means 90% of return differences between portfolios are explained by allocation differences.
Strategic vs. Tactical
| Approach | Description | Typical Changes |
|---|
| Strategic | Long-term target allocation | Rarely changed |
| Tactical | Short-term adjustments | Quarterly or more |
| Dynamic | Rules-based adjustments | Automatic triggers |
Asset Class Characteristics
| Asset Class | Expected Return | Volatility | Role |
|---|
| Equities | Highest | Highest | Growth |
| Bonds | Moderate | Low-Moderate | Income, Stability |
| Cash | Lowest | Lowest | Liquidity, Safety |
| Real Estate | Moderate-High | Moderate | Diversification, Income |
| Commodities | Variable | High | Inflation hedge |
| Alternatives | Variable | Variable | Diversification |
Historical Returns
Long-term annualized returns (US, approximate):
| Asset Class | Return | Volatility |
|---|
| US Stocks | 10% | 16% |
| International Stocks | 8% | 18% |
| US Bonds | 5% | 4% |
| Cash/T-Bills | 3% | 1% |
| REITs | 9% | 18% |
Allocation by Age
Traditional rule of thumb: “100 minus your age” in stocks.
| Age | Stocks | Bonds |
|---|
| 25 | 75% | 25% |
| 40 | 60% | 40% |
| 55 | 45% | 55% |
| 70 | 30% | 70% |
This is a rough guideline only. Individual circumstances (risk tolerance, other assets, income needs) matter more than age alone.
Modern Portfolio Theory
Harry Markowitz (1952) showed how to optimize allocation for maximum return at each risk level - the “efficient frontier.”
Key insight: Combining assets with low correlation reduces portfolio risk below the weighted average of individual risks.
Factors Affecting Allocation
| Factor | Impact on Stocks % |
|---|
| Longer time horizon | Higher |
| Higher risk tolerance | Higher |
| Stable income | Higher |
| Large emergency fund | Higher |
| Near-term spending needs | Lower |
Rebalancing
Asset allocation drifts as markets move. Rebalancing returns the portfolio to target:
- After stocks rise: Sell stocks, buy bonds
- After stocks fall: Sell bonds, buy stocks
This enforces “buy low, sell high” discipline.
Data and Implementation
| Consideration | Details |
|---|
| Review Frequency | Annually at minimum |
| Rebalancing Trigger | 5% drift from target typical |
| Tax Efficiency | Rebalance in tax-advantaged accounts first |
| Costs | Consider transaction costs vs. precision |
