Asset Allocation: How a portfolio is divided among different asset classes.
In the beginning of their investing journey, one of the first questions an informed investor should ask themselves is “where do I actually put my money?” The typical investor has three options for assets to invest in: stocks (equities), bonds (fixed income), and cash (money markets). The total combination of all an investor's invested assets is called a portfolio. The composition of a portfolio by percentage is commonly referred to as “Asset Allocation.” When considering the differences between these different types of assets, it will become clear why asset allocation is a fundamental principle in informed, responsible investing.
If you wish to learn more about different kinds of investments, please see our article titled: “What Can I Invest in? (Asset Classes).”
These three asset categories have vastly different characteristics and risk-return profiles. A portfolio composed of only equities would be extremely volatile but have potential for very high returns. A portfolio of only cash would have little risk but would likely have small returns. Thus, it is important to find an optimal balance of these assets to match an investor's desired risk-return trade-off.
In practice, Asset Allocation is determined mainly by two factors: investment horizon and risk tolerance.
Put simply, the shorter the investment horizon, the less risk one should take, and vice versa. Additionally, the lower the risk tolerance, the less risk one should take, and vice versa. Of course, taking less risk comes at the expense of lower reward.
An investor usually lessens their risk exposure by shifting away from stocks and toward bonds and money market instruments. One key aspect of asset allocation is that over time, a portfolio will change and an investor will either need to change their holdings to maintain their desired asset allocation.
Asset allocation should usually also change over time as the investment horizon decreases.
Theoretical Asset Allocations:
1. Aggressive investor with a long investment horizon
80% Stocks, 20% Bonds
2. Investor who wants to put a down payment down in 5 years
60% Bonds, 20% Cash, 20% Stocks
3. Retiree living on their nest egg
70% Bonds, 25% Cash, 5% Equities
Calculating Asset Allocation:
Shared below are some are several common methods for calculating Asset Allocation:
Online Calculator - such as that provided by Raymond James
20 - Age Method
Take your age and subtract it from 120. This is the percentage of your portfolio that should be equities. This method is designed so that as your age increases, your equity ownership will decrease, resulting in a portfolio that theoretically aligns investment horizon with risk. Other versions of this method are 100 - Age or 110 - Age for more conservative portfolios.
75/25 rule
This method has the investor never holding more than 75% stocks and never less than 25% bonds. As market conditions vary, the investor changes their portfolio composition, but never crosses these key thresholds.