Investing 101: An introduction to asset allocation

This is a guest post from ABCs of Investing, a new site for novice investors. ABCs of Investing offers one short and simple investing post each week. Understanding asset allocation is a key piece of financial literacy.

In my last post at Get Rich Slowly, I explained the basics of passive investing and why it's a good strategy. I explored the differences between index funds and exchange-traded funds (ETFs), and showed how they're great tools for passive investors. My article ended with a breezy “just pick some basic index funds and away you go”. But in reality there are a few more steps before you actually make any investments.

One of the keys to investing is deciding your asset allocation. “But what is asset allocation?” you ask. Asset allocation is the relative amount of each asset class in your portfolio, and it determines how much risk your portfolio has. Still confused? Let's take a closer look.

Asset Classes

An asset class is simply a group of similar investments whose prices tend to move together. In other words, their price movements are at least partially correlated.

Asset classes can be defined on a very general level (“stocks”, “bonds”) or on a more specific level (“oil companies”, “municipal bonds”). Since most oil companies make money based on similar variables, such as the price of oil, most oil company stock prices tend to move up together or down together.

The concept of asset classes is important. One of your goals when building an investment portfolio is to practice diversification, to use asset classes that are not correlated to each other. That is, you want a portfolio in which not every investment moves the same direction at the same time.

When your assets are not correlated, if one of your asset classes performs poorly (such as stocks in 2008), then your other asset classes (such as cash) will help make up for it. This works the other way too — if stocks do well, then your other asset classes will probably lower the overall return.

Diversification lowers the volatility of your portfolio. If you only own stocks, then you could have years where you have -40% returns — or +40% returns. If you own a mix of stocks, bonds, and cash, then your best and worst years will be a lot less dramatic than with an all-stock portfolio.

General asset classes include:

  • Stocks. This could be individual company stocks or shares of a stock mutual fund, ETF, or index fund.
  • Fixed income. Any type of bond, bond mutual fund, or certificate of deposit.
  • Cash. Usually money in a high-interest savings account, but could also include money carefully hidden under your mattress.

There are many different asset classes. It's important to be familiar with the general asset classes (stocks, bonds, cash, real estate, precious metals, etc.) and then learn about more specific classes only if they're applicable to your situation.

Asset Allocation

Asset allocation refers to how much of the various asset classes you have in your portfolio. An older, more conservative investor might have a retirement asset allocation containing mostly fixed-income investments (80% bonds and 20% stocks, for example). A younger, more aggressive investor might have most of their investments in stocks.

Many people make the mistake of thinking you need to choose between all risky assets (stocks) or all safe investments (cash). In reality, you should pick a happy medium. Riskier assets like stocks have a higher expected rate of return. If your investment time horizon is long enough, don't avoid stocks completely just because they're more volatile than fixed income or cash.

A retirement account with a long investment time horizon might have 80% of the portfolio invested in stocks and 20% invested in bonds. If this is too volatile for your stomach and you are have a hard time sleeping at night, consider switching some of the stocks to bonds or cash so that your asset allocation has a less risky profile, such as 60% stocks and 40% bonds.

Investment Time Horizon

The investment time horizon is the length of time until you need the money in your investment account. Simple, right?

Some asset classes, such as cash, are very safe. If you have $5,000 in a savings account, you can sleep very well knowing that in 6 months you will still have at least $5,000 in that account. If you put your $5,000 into a riskier asset class, such as stocks (or a stock mutual fund), then in 6 months your investment might be worth more than $5,000 — or it might be worth less. (Perhaps a lot less.)

If you're investing money you don't need for a long time (20 years, for example), then you might consider investing it in riskier investments such as a stock mutual fund. If you need the money in a shorter time period (like 6 months), then you should invest it in a safe asset class, such as cash. The idea is to maximize the chance that your money will be there when you need it. If you are saving for a house down payment that you need next year, the return you get in that year is not as important as the need for that down payment to retain its value.

There are other factors to consider. For example, somebody approaching retirement might want to start withdrawals from their investments in a few years, but most of the money won't be needed for many years after they start retirement. Going to a 100% bond portfolio in that situation is probably too conservative.

Rebalancing

Rebalancing your portfolio is an important part of investing. Portfolio rebalancing is accomplished by occasionally resetting the proportions of each asset class back to their original percentage.

For example, assume that Susan has just won $50,000 by playing the lottery. After doing some reading, she decides that her portfolio asset allocation will be 60% stocks and 40% bonds.

One year later, Susan checks the value of her portfolio and notices that stocks have declined. They now only make up 50% of her portfolio instead of the 60% she considers ideal. The bonds are also now 50% of her portfolio instead of the original 40%. To return to the original proportions, Susan decides to rebalance her portfolio so the asset allocation is the same as when she started.

To do this, she sells some of the bonds and uses the money to buy some stocks. Another option would be for her to make any new contributions only to stocks (and none to bonds) in order to return to the original allocation.

There are a couple of reasons to rebalance. First, by selling asset classes that have risen in value, and by buying other asset classes that have dropped, you are selling high and buying low. Second, if you don't rebalance, it's possible for your asset allocation (and investment risk) to become radically different from your intended levels.

Summary

Determining the best asset allocation for your portfolio involves a combination of:

  • Investment time horizon — When do you need the money?
  • Risk profile — Can you handle the ups and downs of the stock market?
  • Rebalancing — This is something you should do once a year or so.

It is difficult for the average investor to watch her portfolio value take wild swings every time the markets jump up and down. With proper asset allocation, it's possible to lower the amount of risk in your portfolio while still maintaining a decent return, which should help you get better sleep at night!

Previously at Get Rich Slowly, this author shared an introduction to index funds and passive investing. Catch more great articles for beginning investors at ABCs of Investing.

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the weakonomist
the weakonomist
11 years ago

Thank you for including rebalencing in the post. So many times I see posts about asset allocation and they never talk about doing a rebalence.

AF
AF
11 years ago

You failed to mention that ALL asset classes lost 35% or more during 2008. Diversification failed and so did Buy and Hold. Selling should be a part of any investment strategy yet you don’t mention it at all. Why?

ABCs of Investing
ABCs of Investing
11 years ago

Weakonomist – In my opinion rebalancing is an important part of asset allocation.

AF – I think you meant to say that “all EQUITY asset classes lost 35%+”. There are other asset classes that didn’t lose money in 2008 – cash is one good example.

Snowballer
Snowballer
11 years ago

“Buy and hold” didn’t fail if you didn’t sell anything and are looking for a long term return over a span of 40+ years. Ideally yes we’d have all sold before the crash and bought back in at the lowest point, but if you can figure out how to time the market that precisely you’ll be a billionaire in no time and you sure won’t be telling other people how to do it. In fact the dip means that “buy and hold” with “dollar cost averaging” is going to achieve some pretty impressive long term returns. Any asset you absolutely… Read more »

IndependentOperator
IndependentOperator
11 years ago

This is a really good overview of asset allocation! I’m glad to see coverage of WHY you re-balance and how that helps from a risk AND OVERALL GAINS perspective. The latter point is rarely covered well, and it is such a simple and key point.

Great post.

Matt
Matt
11 years ago

Very nice article. How often should one rebalance their portfolio?

IndependentOperator
IndependentOperator
11 years ago

@Matt: John Bogle did some work on this. The result was that historically speaking the best option is to re-balance either quarterly or annually. Personally, I lean toward quarterly if you are still actively buying (therefore you can rebalance by changing your contribution allocation and you don’t necessarily need to sell) and annually if you are drawing down from your account (want to minimize selling). In general, if you can re-balance by selling and purchasing within your tax advantaged accounts (IRA, 401k), you should do it. Doing so in your taxable account could generate taxable capital gains in the year… Read more »

jnwcmr
jnwcmr
11 years ago

To respond to Matt:
There are two methods to re-balancing:
1) Time – Check every 6 months, or 1 year, and make adjustments as necessary

2) Percentage – Whenever your allocation gets sufficiently out-of-whack, re-balance.

Personally, I use the percentage method. If I’m supposed to be 50% stock, I’ll act when I get lower than 45% or higher than 55% to get things back in line.

Wise Money Matters
Wise Money Matters
11 years ago

Great article. Thanks for the info.

ABCs of Investing
ABCs of Investing
11 years ago

Rebalancing could be a lengthy post by itself! 🙂

Personally, I like to rebalance once a year. For someone like myself who has different investment accounts and different types of investments it’s a bit of work to figure out what the current asset allocation is and then rebalance it all. Once a year is enough for me.

As mentioned in other comments – there are different approaches to rebalancing. I don’t think any of them are wrong as long as you aren’t paying too much in transaction costs.

Tony
Tony
11 years ago

Some studies show that 91% of performance is because of allocation, not timing among other things.

Don
Don
11 years ago

I’m glad to see the comments focused on rebalancing. In Bernstein’s “Intelligent Asset Allocator,” he makes the argument that the reductions in risk you think you are getting from diversification are not realized unless you rebalance. That’s worth repeating. If you are not rebalancing, then the effort to create a diversified investment portfolio is mostly wasted. You are not actually realizing a significant reduction in risk. As others noted to AF, not all asset classes fell by 35% last year. Treasuries were another category that did not. I don’t know the numbers, but I would expect that commercial bonds did… Read more »

J.D.
J.D.
11 years ago

Where did all of these “buy and hold no longer works” people come from? They’ve been all over the place lately, both here and elsewhere on the internet. It’s as if they fail to understand the fundamental concepts of buy and hold. Short rant aside, I wanted to say how please I was to find this guest post in my mailbox. I’ve been wanting to write about asset allocation, but haven’t made time to do it. ABCs of Investing did a fine job. This post will provide a good lead-in to something I want to write about later in the… Read more »

Tracy
Tracy
11 years ago

HI J.D. I have been doing passive investing by dollar-cost-averaging into my mutual funds. It is amazing how $50 a month invested monthly into a few funds really ads up. Thanks for your great blog.

Luke
Luke
11 years ago

I appreciated this thorough introduction to asset allocation, and I like how the author presented the various asset classes. Often times investors forget that diversification goes beyond market sectors, and involves things like branching out into real estate, cash, bonds, equities, etc, for a healthy mix of investments.

Eric
Eric
11 years ago

I love ABCs of Investing! I’ve been a subscriber 🙂

ObliviousInvestor
ObliviousInvestor
11 years ago

Good to see ABCs of Investing here. I’ve been subscribed to it for a few months now and quite enjoy it.

And to add to the topic of rebalancing and how often it should be done, FiveCentNickel touched on this yesterday when he brought up one of the (few) problems with target retirement funds: They’re rebalanced continually rather than annually or quarterly.

Tyler Karaszewski
Tyler Karaszewski
11 years ago

This post covers a lot of the basic, but leaves out one absolutely *crucial* piece of information if you actually want to do this. How do you determine how much risk is appropriate? The article throws around a lot of hypothetical examples: 80/20 is offered up as an example, with a switch to 60/40 suggested if that makes it difficult to sleep at night. The hypothetical “Susan” decides that a 60/40 split is ideal for her, but it doesn’t say how she came to that conclusion. It mentions “risk profile” at the end, but doesn’t say if you determine that… Read more »

EscapeVelocity
EscapeVelocity
11 years ago

What I always wonder about is what I should be including. In practical terms, it’s easiest to treat the 401(k) as a thing in itself with its own asset allocation, since I can move stuff around within it easily but can’t move stuff out, but how much of my other stuff should I consider in determining what that allocation should be? Other retirement funds (Roth IRA)? All investments? Emergency fund? I don’t actually have much cash at all in the 401(k) and I’m not sure whether I need to. @Tyler–I think it actually does make more difference whether you have… Read more »

ABCs of Investing
ABCs of Investing
11 years ago

Tyler – you raise a very good point about determining your asset allocation which I barely touched in this article. In my defence, I didn’t want to write a 10,000 word post that nobody will read (or publish) so that’s why I like to try to pick a subset of the main topic and focus on that. Choosing an asset allocation can be as simple as using a rule of thumb (and hope it works for you) or it could involve an indepth analysis of your financial goals and risk tolerance (ie risk management). I’ll put it on my list… Read more »

Chris
Chris
11 years ago

@ Tony #11.. The 91% research you are quoting is on VARIABILITY, not PERFORMANCE (return). It is a subtle, yet distinct difference.. I agree rebalancing is key, I think that rebalancing with NEW MONEY should be emphasized. The more you can rebalance with new money and not having to sell the better. I prefer NOT dividend reinvesting and using that cash to adjust my allocation accordingly. You want to let your winners run and not sell too early, if possible. I have read studies that show rebalancing every 3-5 years is actually historically best to optimize returns. Great article and… Read more »

Don
Don
11 years ago

@EscapeVelocity: I always consider your portfolio to be those investments you rebalance with. Since you can rebalance your 401(k) internally, and you can rebalance your IRA internally, those are part of your retirement portfolio. Figure out your allocation with those assets. You won’t cash out part of your 401(k) to rebalance into your emergency fund, and you can’t rebalance out of your house into your other investments if it changes in value. So your emergency fund doesn’t count as “cash” in your retirement portfolio, and your house doesn’t count as “real estate”. Whether you need much cash in your retirement… Read more »

Brian S.
Brian S.
11 years ago

“Where did all of these “buy and hold no longer works” people come from? They’ve been all over the place lately, both here and elsewhere on the internet. It’s as if they fail to understand the fundamental concepts of buy and hold.” It’s easy to be a buy and hold person in a Bull market, but not everyone can do it in a Bear market. Unless they can make a darned good argument as to why someone should sell, better than Jack Bogle or William Berstein has already done, then they shold be promptly ignored. Fortunately, this is going to… Read more »

V. Higgins
V. Higgins
11 years ago

I have a question about this. I just started contributing to my company sponsored 401(k), they match up to 7% and I’m contributing 10%. Here’s where there’s a twist. I’m 23, I don’t plan on retiring for at least 40 years. Therefore, since according to some I’m starting early. I put all of my portfolio in stocks. (I also chose this because I believe that the stock market will rebound, and I have more than enough time to wait for it to do so). I’m comfortable with this, probably once I hit about 25-28 I’ll rebalance to include some less… Read more »

JC Webber III
JC Webber III
1 year ago
Reply to  V. Higgins

Nope. That sounds about right.

Wilhelm Scream
Wilhelm Scream
11 years ago

I have an insanely low risk tolerance and I’ve not even graduated! Any time anyone mentiones investing in stocks, I just think “But I could lose money!” I only really feel safe investing in fixed-rate fixed-term bonds, but I do feel like I’m missing out on potential revenue. Any tips?

JC Webber III
JC Webber III
1 year ago
Reply to  Wilhelm Scream

Bonds won’t keep up with inflation. You are loosing purchasing power. You will need enough equities to compensate for the damage inflation does to your nest egg. You have DECADES to recover from a down market. Just do it. 8^)

Jeremy
Jeremy
11 years ago

Another thing that wasn’t touched on here is asset classes themselves and how they break down. I can’t find my copy of ‘Creating Wealth’ by Robert Allen, but it had a chart with stocks, bonds, real estate, gold, collectibles, notes (IOUs with interest paid), and other things. As an example, I often see people say you should have real estate in your portfolio, but they often mean real estate stocks like REITS. Another good way to cover the real estate side is to take back a note if you sell, and have the buyer pay back the loan, with interest.… Read more »

ABCs of Investing
ABCs of Investing
11 years ago

Escape Velocity – in terms of asset allocation (and rebalancing), I like to lump together any accounts or money that has similar time horizons. If you have 14 retirement accounts then it makes sense to consider them as “one account”. If you have a car or house fund then that will probably have its own time line and should be separate. An emergency fund by definition needs to be cash so you can use it in an emergency – although some people will use a CD ladder if they have a large enough EF. In practice this can cause problems… Read more »

IndependentOperator
IndependentOperator
11 years ago

@Don: I understand your points about what you can and can’t control, but I have to disagree. The point of asset allocation is to understand how “exposed” you are to a particular asset type’s fluctuations. So if real estate plummets, how much will your wealth be affected? If you decide you want minimal affect and therefore only want 20% of your wealth invested in real estate, and you have a house that currently accounts for 25% of your wealth, it’s true that you can’t magically reduce that down to 20%. But the point is that you shouldn’t increase investments into,… Read more »

Chris
Chris
11 years ago

@ #24 V. Higgins: Only you can really know if you are too aggressive. You could be right and see your portfolio go gangbusters. You could be wrong and have your portfolio lose value or languish for 10 years. I would say that your plan is fine as long as you know the goods AND the bads. @ #25 Wilhelm Scream: You may, but being able to sleep at night and keep your health is far more important. You can focus on other things like improving your earning potential, etc.. That’s where the real money is made anyway. If losing… Read more »

V. Higgins
V. Higgins
11 years ago

@Chris: Thanks! I know I’m taking a risk, but it’s a calculated one that I’m aware of. And it doesn’t make me lose sleep at night. Like I said, once I’m more in the 25-28 range I’ll probably move things around, if I lose, I lose.

howmuchdoitcost
howmuchdoitcost
6 years ago

These are all good ones. It’s always a good idea to check specific assets, like look at fixed term bonds versus other equity products.

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