When someone starts setting aside money to save for their kids’ college tuition or retirement, they’ll eventually come across an investment strategy known as asset allocation. Asset allocation is important for investors who want to reach a particular goal while striking a balance between maximizing returns and limiting the risk of price volatility in those assets.

What is asset allocation?

Asset allocation is the act of splitting up investment dollars into several different pools—usually stocks, bonds, and cash—with the goal of achieving portfolio diversification. It is the antithesis of putting all one’s eggs in one basket.

How one allocates assets is ultimately a personal decision, and plans can range from simple to complex. Usually, though, the goal is consistent: to limit excessive losses when one asset or group of assets falls in price. The expectation is that the decline in one type of asset will be offset or limited by the performance of other assets in an investor’s portfolio. 

Investors consider two factors when deciding how to allocate their assets. 

• Time horizon.

  How many years does an investor foresee in building wealth? How soon will the investor want to start tapping that wealth?

• Risk tolerance.

  How much nerve does the investor have for the ups and downs of the markets?

Types of assets

Traditional asset allocation focuses on three main types of assets:

• Stocks

  . Stocks have produced the highest average annual rate of return, about 10%, for almost a century. The tradeoff: they have greater volatility. The financial crisis of 2008-09 precipitated a decline of about 50% in the benchmark Standard & Poor’s 500 Index, and the coronavirus crash exceeded 30% between February and March 2020. Even with these setbacks, the S&P 500 tripled from 2007 to the end of 2021.

• Bonds

  . Bonds usually have lower average returns than stocks because they typically are less risky, with the exception of high-yield, or junk, bonds. Total returns for bonds—interest income plus price change—were relatively strong from 2000 through 2020 for two reasons: Stocks, which often are alternatives to bonds, had one of the weakest decades in 2000-2010, and interest rates and bond yields declined steadily to record lows. (As rates fall, bond prices rise.) However, with inflation accelerating in 2021 and the prospect of higher interest rates, the pendulum on bond returns may swing the other way. 

• Cash

  . This usually means cash-equivalent investments such as three-month Treasury bills and money-market funds. Rates for these assets came way down starting in the mid-2000s, like rates for bonds, as the Federal Reserve made unprecedented cuts in key interest rates to near zero during the financial crisis. These investments returned about 0.1% to 0.5%, as of 2021.

• Other

  . Besides the traditional three above, there are other assets that could be included in an asset-allocation plan. These are often called alternative assets or investments, and they include real estate, hedge funds, venture capital, private equity, derivatives, precious metals, and collectibles such as art, antiques, cars, and wine. Alternative assets may offer attractive returns, but also pose greater volatility risk and have much less liquidity, meaning they can be hard to sell on short notice.

Allocation vs. diversification

Asset allocation is the first step in creating an investment portfolio. A traditional mix for long-term investments has been 60% stocks and 40% bonds. The second step is just as important—diversifying your investment portfolio within those assets. Allocation and diversification are both about spreading risk. Diversification within the stocks allocation answers the question—what kinds of stocks? Technology stocks? Financial stocks? Large-cap company stocks? And for bonds—what kinds of bonds? Government bonds? Company bonds? Diversifying the stocks allocation, for example, might consist of 20% each in large-cap, midcap, and small-cap stocks. For the bonds allocation, the investor might put 20% in U.S. Treasury bonds (generally the least risky, less return), and 20% in corporate bonds (generally a bit riskier, but marginally higher returns).

Three examples of portfolio allocation

Consider three hypothetical investors, their goals, and circumstances. 

1. “I want to have $2 million by the time I reach 60. I turn 30 next month. My parents can help me get started with $25,000.’’

   A young investor won’t build $2 million in wealth by age 60 if it’s mostly in bonds and cash because the returns are too low. This investor has a long time horizon and therefore can tolerate more risk, so the asset allocation might lean toward stocks.

2. “I’ll need $200,000 when my child begins college in 10 years. I have saved about $100,000.”

   A parent planning to pay for a child’s college education has a shorter horizon, 10 years, to double the $100,000 set aside. An asset allocation plan might aim for a 50-50 mix of stocks and bonds. An average return of 7% would be needed to reach this goal, based on the Rule of 72.

3. “We expect to retire next year and move from New Jersey to Florida. We want to buy a house there, but not take out a large mortgage, so we hope to make a 50% down payment of about $400,000. Our investment portfolio is valued at about $1.6 million.”

   
   

   The couple buying a home in Florida within a year may have a greater cash allocation set up for the $400,000 down payment. So their $1.6 million portfolio might consist of 35% stocks, 40% bonds, and 25% cash. 

Rebalancing an investment portfolio

Asset allocations can drift over time, as one type of asset rises more rapidly in value than others, or vice versa. A long bull market in stocks may have led an investor’s original 60%-40% stock-bond allocation to become 80-20, for example.

Rebalancing is the process of getting the allocation back to the original mix, or changing the mix altogether if the investor’s circumstances have changed. In the above example, an investor would sell stocks and use the proceeds to buy bonds, restoring the 60-40 blend.

Investors who don’t want the chore of rebalancing can let others do it for them. Target-date funds and robo-advisors monitor asset allocations and automatically rebalance to keep to the investor’s original allocations.

The bottom line

Asset allocation may be the most important determinant of whether an investor can reach a wealth goal, based on the time horizon and on the ability and willingness to accept volatility risk. Many investors use professional wealth managers to help them make the appropriate decisions in creating an asset-allocation plan.