What is Asset Allocation and How It Impacts Your Portfolio

Do you rely on financial media?  If so, you may believe that trying to select stock "winners," timing the stock market, and attempting to identify the "hot" mutual fund manager are essential factors in determining your investing success.

They're not.

Asset allocation is far more critical.  Here's why.

What is asset allocation?

Asset allocation is the process of determining the mix of different types of investments in a portfolio.  An appropriate asset allocation balances risk and reward by spreading investments across various asset classes, like stocks, bonds, and cash.

Portfolio issues

When creating a portfolio, investors should consider their risk tolerance, time horizon, and investment goals. 

1. Risk tolerance refers to your willingness to take risks to achieve higher returns. 

2. Time horizon refers to how long you plan to hold an investment. 

3. Investment goals refer to the objectives you hope to achieve with your investment, like retirement or funding the education of a child or grandchild.

Approaches to asset allocation

The most common way to approach asset allocation is using a mix of stocks, bonds, and cash. 

1. Stocks, also known as equities, are ownership stakes in companies.  Stocks offer the potential for higher returns but also come with higher risk. 

2. Bonds are debt securities issued by companies or governments and typically offer lower returns than stocks but come with lower risk. 

3. Cash, also known as cash equivalents, is the most liquid and risk-free asset class and can provide stability and liquidity to a portfolio.  Cash equivalents include Treasury Bills and Certificates of Deposit issued by banks insured by the FDIC.

Diversification

An important factor in asset allocation is diversification.

A well-diversified portfolio includes different asset classes, like domestic and international stocks, government and corporate bonds, and cash.  By diversifying across various asset classes, you can reduce the overall risk of your portfolio. 

How to allocate your portfolio

One popular method for determining an asset allocation is the "Rule of 100." 

The Rule of 100 states that your age, subtracted from 100, should be the percentage of your portfolio invested in stocks.  For example, at age 30, you should have 70% of your portfolio invested in stocks and the remaining 30% invested in bonds and cash.

Another approach is to use Modern Portfolio Theory (MPT).  This mathematical model helps investors determine the optimal mix of different assets in a portfolio to maximize returns for a given level of risk.

MPT is based on the idea that investors can achieve higher returns by taking more risks.  It recognizes the point of diminishing returns beyond which additional risk does not result in higher expected returns.

Asset allocation isn't static.  As your risk tolerance, time horizon, and investment goals change, you may need to adjust your asset allocation. 

Another trigger for an adjustment is when market conditions change.  It may be necessary to rebalance your portfolio to raise or lower its risk.

How asset allocation impacts your portfolio

Here's an important caveat about asset allocation: Proper asset allocation doesn't guarantee a profit or protect against loss.  It can help mitigate the impact of market fluctuations by spreading your investments among different asset classes, which should reduce volatility.

The impact of asset allocation is significant.  One study found that "for the long-term individual investor who maintains a consistent asset allocation and leans toward index funds, asset allocation determines about 100% of performance."

The study also found that the impact of asset allocation varies according to investment style.  Asset allocation has less of an effect on short-term investors who trade more often, purchase individual stocks, and figure out when to get in and out of the market.

A bigger issue

Understanding the impact of asset allocation on your portfolio is essential, but don't overlook the more significant issue:  How are you investing your hard-earned money?

You can learn important investing lessons from the historical returns of actively managed mutual funds.   The managers of these funds are highly motivated to beat the returns of a risk-adjusted benchmark, like the S&P 500 index.  They try to do so by engaging in stock picking and market timing.

The results of their efforts don't inspire confidence.  As of June 30, 2022, when measured over 15 years, almost 90% of U.S.-based large-cap funds underperformed the S&P 500 index.

Investors in these funds would have achieved better returns by investing in a low-fee index fund that tracked the index instead of attempting to beat it.

You can learn more about the differences between index and actively managed funds here.  To get started with your asset allocation, consult with a low-cost investment advisor today. 

Darrell Armuth founded Sensible in 1994. Since then, he has served hundreds of clients. Darrell is a Certified Public Accountant certified by the state of Nevada.