What is Asset Allocation?

Investing your money can be intimidating when you’re just starting, particularly when it comes to asset allocation. Asset allocation is a term that refers to what percentage of an investment portfolio is invested in different assets, such as stocks, bonds and other securities. 

The percentage to invest in each type depends on several factors, including your goals, age, time horizon, and risk tolerance. 

What is asset allocation? 

When you invest your money, you can choose to buy different types of investments. 

As you invest your money, it’s a good idea to invest in a variety of stocks and bonds rather than just a few. Spreading your money across many different stocks and bonds helps reduce your losses if one company performs poorly; the potential returns of the other investments can offset that company’s losses. 

As you build your investment portfolio and invest in different stocks and bonds, what percentage of your portfolio is invested in each asset class determines your asset allocation. 

Why is asset allocation important? 

Your portfolio’s asset allocation is important because it determines the level of risk you are willing to accept for the potential returns over the long term. 

Different asset classes respond to economic changes in different ways, so investing in multiple types of assets improves the odds of earning returns and reducing losses. 

Over time, your positions may fluctuate in value due to market conditions, so it’s a good practice to rebalance your portfolio periodically. Portfolio rebalancing involves selling or buying new investments to bring the portfolio back to its allocation mix. 

Your asset allocation isn’t fixed. The right asset allocation for you varies based on your goals and age, and it changes over time. What works for you now will likely differ from the asset allocation you need in 20 years. It’s wise to periodically review and adjust your asset allocation — or use a robo advisor that will handle those adjustments for you. 

3 asset types to consider

There are many types of investments you can invest in, but assets generally fall into three classes: 

Stocks

Stocks, also known as equities, give you a slice of ownership in a company. When you purchase stocks, you become a shareholder. If the value of the stock increases, so will the value of the portfolio. Some stocks even pay dividends– a share of its profits– which is money into your account. Compared to other investment classes, stocks are a higher-risk choice, but they have the potential for higher returns. The return and principal value of an investment in stocks will fluctuate with changes in market conditions so that shares, when redeemed, may be worth more or less than original cost.

Bonds

Unlike stocks, which are shares of companies, bonds are a type of debt security. Governments and companies issue bonds as a way to raise money for their projects. Bonds function like loans; you lend money to the issuer, and, in return, the issuer promises to pay interest as well as the bond’s principal. Financial experts generally consider bonds a safer investment than stocks, but they tend to have lower returns. Bonds, if held to maturity, offer both a fixed rate of return and fixed principal value. 

Cash or cash equivalents

Cash and cash equivalents refer to assets like savings deposits, certificates of deposit (CDs) or treasury bills. They’re usually the safest form of investment, but they typically have the lowest returns overall. CDs are insured by the FDIC and offer a fixed rate of return. 

Other common investments, such as exchange-traded funds (ETFs), index funds or mutual funds, fall under those three main asset classes because the holdings within the fund are made up of those securities. For example, you can buy shares of an ETF that invests in stocks in the technology sector, or you can invest in a bond mutual fund that invests in a variety of municipal bonds. 

There are other investment options, such as real estate or cryptocurrency. But those categories tend to have their own pros and cons and pose different levels of risk. Before investing in alternative investment classes, make sure you understand the risks and benefits and how it fits into your overall investment strategy.

Factors that affect asset allocation

When considering which asset allocation is best for you, three of the variables you should consider are:  

Risk tolerance

The level of risk you are willing to take on is known as your risk tolerance. It reflects your ability to lose the money you invest for the chance of a higher return. Aggressive investors have high risk tolerances, and will have an asset allocation that is primarily in stocks. Conservative investors with low risk tolerances will invest primarily in lower-risk options, like bonds and cash equivalents. 

Goals

Your goals impact your asset allocation because you may want to be more aggressive to achieve them. If you have large financial goals, such as retiring early or buying a dream beach house, you may have to take on more risk to make those goals happen.

Time/Age

How long you have to invest can help determine your asset allocation. Those that are young or have several decades to achieve their goals can generally afford to invest more aggressively since they have more time to recover from stock market changes. By contrast, those that are older or have shorter time horizons have less time to make up for losses, so they may not be able to afford to take on as much risk. 

Asset allocation by age

Your age impacts your target asset allocation because your portfolio will need to be more conservative as you draw closer to retirement. 

One rule of thumb some experts use is the "Rule of 100." Subtract your age from 100, and the resulting number is the percentage of your portfolio that should be in stocks. For example, if you're 25:

100-25=75

Following the Rule of 100, 75% of your portfolio should be allocated to stocks. 

This theory operates under the assumption that younger people have more time to weather market fluctuations. And as you get older, your portfolio should get increasingly conservative to protect your money for retirement. 

The Rule of 100 may not be the right fit for everyone, but it may be a good starting point as you think about how to invest your portfolio.  

Strategic asset allocation

Figuring out the right asset allocation is an important step. It helps create a guide map for how to manage your portfolio so you can make informed decisions as you invest your money. 

Depending on your goals, time horizon and ability to tolerate risk, you may choose one of the following asset allocation strategies: 

Income

An income-focused allocation is made up of lower-risk investments, including bonds and cash equivalents, that attempt to generate and preserve capital. These allocations are best for those that have shorter investment time horizons and minimal risk tolerances. 

Common income-focused asset allocations include: 

• 100% bonds

• 80% bonds/20% stocks

Balanced

In a balanced portfolio, assets are invested in both stocks and bonds to attempt to earn competitive returns while reducing potential losses. An investor with a balanced asset allocation can tolerate short-term price fluctuations and is comfortable with moderate growth potential. 

Common balanced asset allocations include: 

• 50% bonds/50% stocks

• 60% bonds/40% stocks

Growth

A growth-focused portfolio takes on more risk for the potential of higher returns. Growth-focused investors tend to be younger with a longer time horizon to reach their financial goals. 

Common growth asset allocations include: 

• 100% stocks

• 80% stocks/20% bonds

Below is a snapshot of how different asset allocations have performed between 1926 and 2021: 

Source: Vanguard

As you can see, a portfolio with an asset allocation that is 100% bonds had the lowest average return at 6.3%, but it also had the most favorable return in its worst year. By contrast, a growth portfolio that is 100% stocks had the highest average return. But during its worst year, it decreased 43.1%; for investors with short time horizons or low risk tolerances, such a drop can be devastating, so it’s important to keep your goals and tolerance for risk in mind when designing your portfolio’s asset allocation. 

Creating the right investment portfolio

Your investment portfolio should contain a mix of stocks, bonds and cash. What determines the right mix is based on your age, goals and the level of investing risk you can handle. If you are worried you’ll choose the wrong mix, you can use a platform like Acorns Invest. 

Acorns will ask you questions about your goals, timeline and risk tolerance and use that information to recommend an ETF portfolio. It recommends a diversified portfolio with an asset allocation that suits your profile, and each fund is managed by leading investment firms like Vanguard and Black Rock.

With Acorns’ age-based portfolios, your asset allocation and portfolio is automatically adjusted as you age, attempting to maximize your growth potential while reducing your risk as you approach your goal. 

It costs as little as $3 per month to invest through Acorns, and you can start investing with as little as $5. Sign up for Acorns Invest today to start growing your oak!