Asset allocation is the process of allocating your investments among various asset classes. At the highest level, the three main asset classes are stocks, bonds and cash. Within these asset classes there are sub-asset classes such as small cap stocks, international stocks, short-term bonds and many, many others. Sub-asset classes may be designated by traits such as a growth or value strategy, where the investments are domiciled (U.S. or non-U.S.), the duration of the bond holdings and the type of cash-like investments.
There are alternative asset classes as well that include assets like gold and precious metals, commodities, real estate and crypto currencies like Bitcoin.
What is asset allocation?
Asset allocation is an investment strategy that allocates portions of your investment portfolio among various asset classes. If done properly, your asset allocation should reflect your risk tolerance, the time frame when you will need to tap into your investments and should be aligned with your investment and financial goals.
Part of the theory behind asset allocation is to blend some asset classes that are non-correlating with other parts of the portfolio. For example the bulk of your portfolio might be allocated to a combination of stocks, bonds and cash. This will include a number of sub-asset classes within these broad categories.
Alternative assets will often have a relatively low correlation to more traditional stock and bond holdings. Having a low correlation means that the market or economic factors that impact one type of investment will not impact another in the same way. As an example, the correlation of gold to U.S. large cap stocks was recently -0.04. This means that the correlation is so low that there is virtually no correlation in the price movement of these two asset classes.
The correlation between U.S. large cap stocks and domestic bonds is -0.21 meaning that the correlation between the two asset classes is both very low and negative. A negative correlation means the two asset classes will generally move in opposite directions based on the same set of market and economic factors.
Asset allocation is about trying to achieve the right balance between risk and return in constructing your investment portfolio. When implementing an asset allocation strategy it’s generally best to do this across your entire portfolio. This might include a taxable brokerage account, as well as retirement accounts like a 401(k) or an IRA. This isn’t to say that your asset allocation has to be exactly the same in each account, but you should review it on an overall portfolio basis across all accounts that you might have to ensure it fits with your overall financial goals.
Ideally your asset allocation strategy will be an outgrowth of your overall financial planning work. Your asset allocation should be an outgrowth of your age, time horizon to reach your various financial goals and our risk tolerance.
What is strategic asset allocation?
Strategic asset allocation is what we often think about when we hear the term asset allocation. Under strategic asset allocation, the investor will set a target asset allocation with target allocation percentages for the asset classes utilized in the asset allocation.
In order to remain invested in line with their target asset allocation, investors will generally rebalance their portfolio back to the target allocation periodically. This may mean buying into asset classes that are below their target allocation and selling from asset classes where they are over allocated. This can also be accomplished, all or in part, by directing new money to be invested in those asset classes where the current allocation is below the target allocation.
Typically investors will set thresholds that would trigger rebalancing, perhaps assets classes that are +/- 5% away from their target allocation. It generally is not a good idea to rebalance too often, quarterly, semi-annually or annually.
Asset allocation strategies
There are a number of variations on the basic asset allocation strategy. Here are a few.
Asset allocation by risk profile:
Conservative portfolio
A conservative portfolio would generally have an asset allocation designed to provide a high level of principal protection. There is no set asset allocation for a conservative portfolio. This portfolio might have an allocation in these ranges:
- Bonds and fixed income 70% - 75%
- Cash including CDs and money market funds 5% - 15%
- Stocks 15% - 20%
Though the focus is on low-risk holdings, a stock component invested in index funds or blue chip stocks can provide some upside potential to protect against inflation.
Moderately conservative portfolio
A moderately conservative portfolio would likely be used by an investor who is still focused on capital preservation, but who is comfortable taking on a bit more risk. Their equity allocation will generally be a bit higher to offset the impact of inflation on the purchasing power of their assets over time.
This portfolio might have an allocation in these ranges:
- Bonds and fixed income 55% - 60%
- Cash including CDs and money market funds 5% - 10%
- Stocks 35% - 40%
Investors employing this type of portfolio allocation often consider using a current income strategy that includes dividend paying securities.
Moderately aggressive portfolio
A moderately aggressive portfolio is sometimes also referred to as a balanced portfolio. This is because the asset allocation in this type of portfolio is typically fairly well balanced between stocks and fixed income and cash
This portfolio might have an allocation in these ranges:
- Bonds and fixed income 35% - 40%
- Cash including CDs and money market funds 5% - 10%
- Stocks 50% - 60%
This portfolio allocation provides a balance between growth from the allocation to stocks and income from the fixed income allocation. This type of portfolio allocation may be best for someone with a longer time horizon who needs a bit more growth from their investments.
Aggressive Portfolio
An aggressive will generally consist mostly of equities, subjecting the portfolio to greater price fluctuations and more risk. The objective of this type of portfolio is primarily the growth of capital.
This portfolio might have an allocation in these ranges:
- Bonds and fixed income 20% - 30%
- Cash including CDs and money market funds 5% - 10%
- Stocks 60% - 70%
This portfolio allocation focuses on growth via the stock allocation. The fixed income allocation provides a level of diversification and reduces risk a bit.
Very Aggressive Portfolio
A very aggressive portfolio will consist entirely or almost entirely of stocks. This type of allocation can result in very wide ranges of short-term fluctuation and can be very risky. This is most appropriate for an aggressive investor who has a long-time until they will need the money for retirement or other goals.
Other approaches to asset allocation include:
Asset Allocation by Age (rule of thumb)
This rule of thumb states that your allocation to equities should be based on a formula of 100 minus your age. By this method, a 30-year old should have 70% of their portfolio allocated to stocks. A 50-year old would have 50% of their portfolio allocated to stocks.
The problem with this, like any rule of thumb, is that one size rarely fits all when it comes to investing. The investing needs of every 50-year old are not identical. Some may be more or less risk averse. Some may need more allocated to stock, some less.
Asset allocation should be tied to your financial planning and your unique situation, not governed by a rule of thumb.
Tactical Asset Allocation
A strategic asset allocation is fairly rigid in that the goal is to stay as close to the target asset allocation for the portfolio as possible. As mentioned above, this is often done via periodic rebalancing back to the portfolio’s target allocation.
Tactical asset allocation is a variation on the strategic asset allocation theme that employs a degree of market timing. While an investor would still set a target allocation for their portfolio, this strategy is a moderately active strategy when compared to the passive strategic allocation methodology.
Tactical asset allocation allows for investors to periodically over or underweight portions of their portfolio to capture short-term gains due to the direction of the market. For example, if their allocation to small cap stocks is overweight due to recent gains, but they think this asset class has a ways to go on the upside, they may let the allocation to small cap stocks remain overweight based on a tactical strategy.
Ultimately the investor would rebalance back to the target asset allocation. Tactical asset allocation adds a touch of market timing and a bit more risk in that if the investor’s call on allowing a portion of their allocation to be overweight they could be wrong. This could expose the portfolio to a greater level of risk than using a more traditional approach to asset allocation.
Dynamic Asset Allocation
Dynamic asset allocation takes tactical asset allocation a step further along the active management scale.
Instead of having a set target asset allocation that an investor would periodically rebalance back to, a dynamic asset allocation is adjusted based on the investor’s sense of where the markets are heading, the health of the economy and other factors.
A dynamic asset allocation strategy can be costly to run in terms of potential transaction costs and realizing capital gains in taxable accounts. It can also be riskier as the asset allocation is based upon the investor’s perception of where things are headed, that perception can be wrong at times. When that happens, the portfolio can be subject to losses.
This strategy may be right for an active investor who stays attuned to what’s going on in the markets and the economy. It might also be appropriate for an investor who is OK with assuming a greater level of portfolio risk.
Insured Asset Allocation
With an insured asset allocation, the investors would establish a base level for their portfolio below which they don’t want the value to fall. As long as the value of the portfolio remains above their base level, you might engage in strategic asset allocation or a more active version of asset allocation. Essentially, investors using this strategy generally want to grow the value of their portfolio but want to limit their overall downside risk.
If the portfolio value hits their base level, an investor using this strategy would shift all or most of their assets out of risky holdings such as stocks and bonds and into ultra-low risk holdings such as cash or Treasury securities.
On the one hand, this is touted as a method of controlling risk that might be appropriate for a retiree. On the other hand, this type of strategy poses its own set of risks. What would trigger the investor to get back into more risky assets? What are the costs of liquidating their positions to move to these ultra-low risk strategies? Are they setting themselves up for a situation where the lack of portfolio growth increases their risk of running out of money during retirement?
Anyone considering this approach to asset allocation would be wise to consult with a financial advisor to weigh the pros and cons for their situation.
Integrated Asset Allocation
An integrated asset allocation will be established based on a combination of your risk tolerance and your market expectations. This takes into account most of the factors mentioned in one or more of the strategies outlined above. But in this case the investor would not necessarily set a static target allocation. This type of strategy has many of the elements of an actively managed approach.
How to Choose the Right Approach for You
In deciding the best approach to asset allocation for your situation, there are a number of factors to take into consideration. These include:
- Do you have the time and the investment experience to devote to an active or semi-active approach to asset allocation? If not, perhaps using a strategic approach is best for you.
- Your age and risk tolerance should come into play.
How you implement your asset allocation approach is important as well. Individual stocks and bonds can be solid investment choices, but this also takes extra work to stay on top of these holdings including understanding any company specific issues related to individual stocks.
Using mutual funds and ETFs can be helpful in implementing all or part of an asset allocation plan. This is especially true with regard to index mutual funds and ETFs. Index funds generally follow a market benchmark unique to a specific asset class and you won’t have to worry about style drift in the fund’s investment style and you might have to with an actively managed fund.
Overall your approach to investing and asset allocation should tie into your overall financial plan and should largely depend upon your stage of life. It can be beneficial to work with a qualified financial advisor to help you implement and manage an asset allocation approach that best fits your situation.
