Asset Allocation: What It Is, Why It Matters, and How to Get It Right

Asset Allocation

Asset allocation is a term you’ll hear a lot when you read up on investing, and although it sounds fancy and technical, it’s actually a pretty simple idea.

To get a sense of what it is and how it works, imagine that you’re driving your kids to school or daycare in the morning. Your main goal is just to get there on time, though it would be nice to get there a little early. But more than anything you want to avoid being late.

With that in mind, you could choose to:

  1. Drive as fast as you can. This gives you the best chance of getting there early, and it may also feel like the necessary option if you’re getting a late start. It also puts you at the greatest risk of being stopped for a ticket or getting in an accident, either of which would make you late.
  2. Drive as slow as possible. You’ll probably avoid any major accidents, but you’ll have to leave extra early if you want to get there on time.
  3. Drive at about the speed limit. You won’t get to school or daycare super early, but you also reduce the risk of running late due to a ticket or accident. And unlike driving slowly, you can probably get there on time without leaving earlier than normal.

This is essentially the same decision you have when it comes to asset allocation.

Your asset allocation is simply the way in which you divide your money between different types of investments. And the balance you strike has a big impact on both your expected return and the amount of risk you take on.

Investing 100% of your money in the stock market is like driving as fast as you can. It technically gives you the best chance to reach your investment goals as soon as possible, but it comes with the biggest downside risk. The stock market tends to crash from time to time, and a big drop at the wrong time could force you to delay some of your goals.

Putting 100% of your money into a savings account is like driving as slow as possible. You completely remove the risk of a stock market crash, but you need to start saving a lot more money a lot sooner if you want to reach your long-term goals along any reasonable timeline.

But by mixing aggressive investments like stocks with more conservative investments like bonds, you can accomplish two things:

  1. You get the superior long-term returns the stock market provides.
  2. You get the protection that bonds provide, making it a smoother journey with a slightly more predictable endpoint.

This is like driving at about the speed limit. The right mix of investments is fast enough to get you there on time without risking too much in the process.

Of course, even within that basic framework, everyone does things a little differently. Some people try to drive exactly speed limit. Some people are comfortable driving 5-10 miles over the speed limit. Some people might drive a little less than the speed limit.

Similarly, the right asset allocation for you depends on both your personal preferences and your personal goals. The rest of this post will help you figure out exactly what your personal asset allocation should be.

Here’s what we’re going to cover:

  • Part 1: Why asset allocation is so important
  • Part 2: What the major asset classes are and how they work
  • Part 3: How to choose your asset allocation

Part 1: Why asset allocation is so important

Before getting into the nitty gritty of choosing an asset allocation, let’s talk about why it even matters in the first place.

Remember, your asset allocation is simply the way in which you divide your money between high-risk, high-return investments like stocks and low-risk, low-return investments like bonds. And there are two big reasons why this decision is such an important part of your investment plan.

1. Your returns are mostly out of your control, but…

When you invest, you’re doing it because you expect some kind of return, right? If that’s the goal then it’s important to understand where that return will come from so that you can create a strategy designed to actually capture some of it.

This paper by Roger Ibbotson has all the details, but the upshot is that your investment return will be determined by three main factors:

  1. 75% of your return comes from something you have no control over: the overall market return. That is, simply deciding to invest at all will expose you to most of the same big market swings that everyone else experiences. What this really means is that most of your return is not at all a reflection of you as an investor or your specific strategy, but simply a reflection of what’s going on in the world as a whole.
  2. 15% of your return comes from how much you decide to expose yourself to those market movements. This is your asset allocation.
  3. 10% of your return comes from the specific investment choices you make. That is, the specific mutual funds, ETFs, stocks, bonds, etc. that you decide to use.

So, what does that mean?

First, it means that only about 25% of your personal investment return comes from factors that are under your control. For the most part you’re subject to the whims of the market.

That can be difficult to accept, but coming to grips with that reality actually frees you up to not stress so much about trying to find the perfect investment strategy. Your choices do matter, but not as much as you think.

Second, that 10% of your return that comes from your specific investment choices is a bit of a false flag when you remember that a simple index-based portfolio beats the professional stock-pickers 80-90% of the time. In other words, trying to influence that 10% by picking market-beating investments is a fool’s errand. You’re better off sticking with good, low-cost index funds, which frees you from even having to worry about this 10%.

All of which means that your asset allocation is essentially the only major decision that affects your investment return. With 85% covered by the overall market and 10% covered by your market-mimicking index funds, the final 15% of your return is determined by your asset allocation.

When it’s the main factor that you can control, it’s worth doing it right.

Quick note: There are other decisions that affect your return, such as costs and which accounts you use. The study mentioned here purposefully ignores those factors in order to look specifically at the process of constructing an investment portfolio.

2. You can’t get returns without risk

A big part of investing is managing the level of risk you want to take on. But risk is kind of a strange word in the investment world.

When an investment is labeled as risky, that simply means that there is uncertainty about the return you’ll get from it.

As an example, stocks are called risky because you can never be sure what they’ll do. Some years they’re up big. Other years they’re down big. There’s a lot of uncertainty involved.

At the other end of the spectrum is a savings account. Yes, interest rates change over time. But basically you know exactly what will be in your account from day to day. That’s as certain as it gets.

And there are two big points to understand here when it comes to choosing an asset allocation.

First, if you want to reach for higher returns, you’ll have to choose a more aggressive asset allocation that comes with a lower level of certainty about whether you’ll actually get those returns.

If someone is telling you about a way to get higher returns without increased risk, then they’re selling you something that doesn’t exist (unless they’re talking about simple diversification).

Second — and this is a point that’s often overlooked — certainty about returns brings its own set of risks. This is why I say that risk is a strange word when it’s used in the context of investing.

With a savings account you can be certain of your balance from day to day, but you’re running the risk that the value of your money will decrease due to inflation. Over short periods of time this isn’t a big deal. But over long periods of time it matters a lot.

This is the main reason why people suggest that long-term investors put their money into riskier investments, like the stock market; there’s actually risk on both ends of the spectrum.

So, here are two things you’ll want to keep in mind about risk and return when choosing your asset allocation:

  1. If you want the possibility of higher returns, you’ll have to accept more uncertainty about whether you’ll get them. That’s the trade-off that comes from putting a higher percentage of your money in the stock market.
  2. Over the long-term, there actually IS risk involved with even “low risk” investments. That’s why you’ll likely want a significant amount of your long-term money in the stock market.

Part 2: What are the major asset classes and how do they work?

asset allocation - asset classes

Okay, so at its core asset allocation is all about striking a balance between different types of investments so that your money grows enough to reach your goals without taking on more risk than you can either afford or are comfortable with.

With that mission statement, you’ll want a good understanding of the different types of investments available to you and how they work so that you can balance them appropriately.

In investment terminology, each different type of investment is called an asset class, and you can think of asset classes a lot like you think of types of cars.

While there are a TON of different individual cars and individual investments out there, each with their own unique set of features and nuances, they can all be grouped into just a few major categories that tell you most of what you need to know.

With cars, we have categories like sedan, minivan, and SUV. Not all cars within each category are exactly the same, but they’re pretty similar along the major characteristics like size, power and gas mileage.

With investments, the major categories (asset classes) are stocks, bonds, and cash. Just as with cars, not everything within each category is exactly the same. But they share similar characteristics like expected risk and return.

Here’s a basic overview of each asset class.

Cash

For the most part, cash refers to money you have in checking accounts and savings accounts. It can also refer to money market funds within an investment account.

Cash has the lowest expected return but also the highest amount of certainty. You won’t get rich investing in a savings account, but you will know for sure that the money will be there when you need it.

This is the perfect place for short-term goals like building an emergency fund or saving for a house, but it usually isn’t ideal for long-term goals because the return is so small that your actual purchasing power will decrease due to inflation (the flip-side of risk we talked about above).

Bonds

Bonds are technically loans you make to companies, governments, or other organizations. You give them a certain amount of money (your investment) for a defined period of time, they pay you interest over that period, and when the period ends they return your initial investment.

You can buy individual bonds, but it’s much more common to invest in mutual funds that own a collection of bonds. For example, you can buy into a mutual fund that owns the entire US bond market, one that invests only in bonds issued by the US government, and countless other varieties.

Bonds have a medium expected return with a medium amount of risk. You don’t know for sure what you’ll get here, but the ups and downs won’t be as large as with the stock market. Experts seem to expect 2-5% returns for bonds over the next 10-30 years, though that’s highly unpredictable.

Bonds are particularly good as the conservative part of your asset allocation, balancing out the higher-risk, higher-return nature of stocks.

Stocks

Stocks represent ownership in a company. When you buy a company’s stock, you become a part owner and you share in both the profits and the losses of that company.

As an owner, you have both an unlimited potential for gain and the potential to lose it all. The ups and downs of the stock market can be very high from year to year, and even from day to day.

You can smooth out the ride by diversiyfing your stock portfolio over many different companies, reducing the risk that any one company could sink you. You can also take heart in the fact that stock market returns have always been positive over the long-term, which is why they’re an important part of any long-term investment plan.

Other asset classes

You’ll probably hear people talk about other types of investments like alternatives, gold, and real estate, but my honest opinion is that you can typically ignore them.

For most people, all you need to build a strong investment strategy are the three above. But if you’d really like to dig deeper, I’d suggest the following two books:

Part 3: How to choose your asset allocation

asset allocation - how to choose your asset allocation

Imagine someone asked you to decide right now how you want to divide your time between family, friends, work, and play for the rest of your life.

What would your answer be? What do you think is the optimal balance given your personal goals, values, and situation?

If you’re thinking to yourself something along the lines of “I have no freaking clue!”, join the club.

It’s almost an impossible question to answer. There are so many variables, so many unknowns, and even your best guess most likely feels like a shot in the dark.

For most people, trying to figure out the right asset allocation feels exactly the same way. You know it’s important, but you don’t really have a good way of figuring out what it should be.

The truth is that there IS no right answer, especially if you’re new to investing and making this decision for the first time. Asset allocation is part science and part personal preference, and you can only truly get a handle on the personal preference part through experience.

But you can absolutely get on the right track.

Below is a questionnaire that will help you set a specific target asset allocation, as well as some factors you can consider when making adjustments based on your personal values and goals.

Together, they’ll help you land on a specific asset allocation you can use to implement your personal investment plan.

How to set your target asset allocation

There’s no surefire way to determine the exact right asset allocation for you, but there are some ways to get in the ballpark and that’s exactly what I’m going to share with you here.

Here’s essentially the same questionnaire I use with my clients to get an initial sense of their investment profile:

Mom and Dad Money Asset Allocation Questionnaire

Click the link, answer the questions, and you’ll get a target asset allocation based on your responses.

Now, keep in mind that the answer you get here is NOT a specific recommendation. There are many factors that go into this decision, including your specific goals, values, and circumstances, and no questionnaire can factor all of that in.

But it’s a good start that gets you in the ballpark, and from there it’s a matter of making adjustments based on your personal situation.

So now let’s talk about why you might make adjustments.

Quick note: I adapted this from Vanguard’s Investor Questionnaire, which they have published and made available for use by both financial planners and individuals.

Potential reasons to invest more aggressively

What are some situations in which you should increase your allocation to stocks, exposing yourself to more risk in search of higher returns?

To be quite honest, unless you’re an experienced investor there aren’t many cases where I would recommend doing that.

Most people don’t really have a good sense of their personal risk tolerance until they’ve lived through a big market crash, and in the meantime sticking to a more conservative portfolio is more likely to lead to better behavior.

Still, here are a few situations in which you could at least consider investing more aggressively.

1. You’ve been through a market crash and it didn’t scare you

If you’ve already lived through a big market crash like the one in 2008, didn’t sell out of your investments at the time, and actually kept contributing all the way through it, you’ve proven that you can handle that kind of downswing.

If doing that was difficult, it’s probably good evidence that your asset allocation at the time was exactly what it should be. Sticking with it was hard, but you made it through.

If doing so was easy, and if you weren’t scared or concerned as the market continued to fall, then maybe you can handle an even larger allocation to stocks.

2. Your investment timeline is flexible

The benefit of the stock market is a higher expected return. The downside is that there’s huge variability in the returns you actually receive.

You can’t count on the stock market to help you hit a specific financial target on a specific date, because you just don’t know what it’s going to do during any given day, month, year, or even decade. That’s why using the stock market for short-term goals is generally a bad idea.

But if you have a lot of flexibility with your goal, and if you could delay it for a potentially significant amount of time without stress or hardship, then you may be able to take on some extra risk with the hope of getting higher returns and reaching your goal even sooner.

3. You’re saving more than you need to be

If your savings rate is significantly higher than what it needs to be, you could consider investing more aggressively for the potential of a double bonus.

If it works out and you get higher returns, that will compound with your savings rate to get you to your goal even quicker.

If it doesn’t work out and you get lower returns, your savings rate will help to offset that loss and keep you on track.

Potential reasons to invest more conservatively

On the flip side, there are a number of reasons to consider investing less aggressively and put more of your money into bonds than what the questionnaire suggests.

Here are a few.

1. You don’t need higher returns

Here’s a simple spreadsheet that helps you figure out the rate of return you need given your savings goal, your current savings, and your monthly contribution: Savings Calculator.

If you run the numbers yourself and find that you can reach your goal with lower returns, why take the risk of NOT reaching it by stretching for higher returns?

Investing more conservatively will not only increase your odds of hitting your goal on time, but it will make for an easier ride along the way.

The trade-off will be the lost potential to end up with even more money, but as the saying goes: “pigs get fat, hogs get slaughtered.”

2. You haven’t experienced a market crash

If you haven’t lived through a big market crash, the truth is that you don’t know what it feels like to watch your account balance drop and drop and drop with seemingly no end in sight.

It’s a scary thing to live through and even the most experienced investors have trouble sticking to their plan when things get bad.

Until you’ve been there you don’t know how you’ll react, and there’s also a decent chance that you overstated your risk tolerance when completing the questionnaire, leading to a more aggressive recommendation than what you can truly handle.

I’m a big fan of Rick Ferri’s Flight Path approach to asset allocation because it factors in this very thing. It encourages investors to start out relatively conservatively and get more aggressive as you gain experience, IF that experience suggests that you can handle being more aggressive.

Remember that when you first start out your savings rate is far more important than your investment return. So you’re not missing much if you invest more conservatively at the start, and the potential bonus is that the next market crash doesn’t scare you off from investing altogether.

3. Investing makes you nervous

If you know you’re supposed to be investing but you’re scared about the possibility of losing money, it’s okay to be more conservative than the “norm”.

Like I just said, your savings rate is far more important as you start out anyways. So start making those contributions, dip your toes into investing with a conservative plan, and if needed make adjustments as you gain experience.

4. Your investment timeline is not flexible

If you’re dead set on reaching your goal at a specific point in time, and especially if that time is in the near future, the stock market carries some significant risks.

In general, I’m not a big fan of using the stock market for any goal that’s less than 3 years away. I’d rather put my money in a savings account and know it will be there when I want it.

And even for longer-term goals, say 3-10 years out, I’ll generally be pretty conservative unless I’m willing to be flexible about when I’m able to reach that goal.

If you have a strict timeline, just know that a higher allocation to stocks introduces more uncertainty about hitting that timeline.

When to re-evaluate your asset allocation

In most cases, your investment plan should largely be set-it-and-forget-it. Other than occasional rebalancing, your job is to keep contributing and let your investments do their thing through the ups and downs.

But it is worth re-evaluating your asset allocation from time to time, especially when something significant has changed in your life or when your financial goals have changed. In those cases your need and/or ability to handle risk may change as well, meaning that a new strategy might be a good idea.

Here are a few examples of situations where it’s worth re-evaluating your asset allocation:

  • Marriage or divorce
  • Receiving an inheritance
  • Significant change in retirement goals
  • You just lived through a big market crash AND the subsequent recovery (perfect time to reflect on your true risk tolerance, once things are calm again)
  • A big, unexpected financial commitment, such as caring for aging parents

Make your best educated guess and get started

Even with the help of a questionnaire, deciding on your asset allocation can be intimidating. It feels important and there are a lot of unknowns, which may make you hesitant to pull the trigger.

So know this: there is no perfect answer but there are plenty of “good enough” answers. If you follow the steps laid out here, you will almost certainly end up in the “good enough” camp with plenty of time over the rest of your investment life to make adjustments as needed.

So make a decision, put it in place, and get back to saving money (which is the real way to get ahead!).

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