What is Asset Allocation in Investing? Why It Matters

Asset allocation is an investing process in which you spread your available dollars across mutiple asset classes. The three main asset classes are stocks, bonds, and cash. When you allocate your dollars, you decide how much to send to each one of these asset classes.

For example, say that you had $1,000 to invest. You might send $800 towards stocks, $150 toward bonds, and keep $50 in cash. In this example, you have an 80/15/5 asset allocation between stocks, bonds, and cash, respectively.

The point of asset allocation is to balance the risk you are willing to take as you invest with the return that you want your investments to provide. When you decide how to allocate your dollars, you want to consider your age, your goals, and your risk tolerance.

For simplicity's sake, there are three primary investments that most investors will allocate their dollars to. Those investments are stocks, bonds, and cash or cash equivalents. The idea behind investment allocation is to allocate your dollars to investments that align with your age, goals, and risk tolerance. You can break stocks, bonds, and cash into two categories.

Stocks or stock funds, such as index funds, mutual funds, and ETFs are usually considered to be higher risk investments than bonds or cash. The reason for this is that these investments are volatile. Volatility is a measure of how often and how much an investments price changes.

Some years stock prices go up 20%, and other years they go down 20%. However, investments that are subject to more volatility will also offer the potential for higher returns. In other words, stocks will make you more money than bonds and cash over extended periods of time.

If you are an investor that can mange the volatility of the stock market, you might allocate more of your available dollars towards stocks. This brings more risk, but it also offers the possibility of higher returns, which is what some investors are after.

Lower risk investments are less volatile than higher risk investments are. In general, bonds are considered to be less volatile than stocks, which is why they are often considered less risky. However, since bonds are less risky than stocks you will not get as high of a return.

If you prefer less volatile investments, you might allocate more of your available dollars towards bonds. Also keep in mind that bonds are not risk free even though they are less volatile than stocks. Bonds have interest rate risk, credit/default risk, and inflation risk.

Although cash is not usually considered an investment, some investors will allocate a small percentage of dollars towards cash accounts such as CDs, high yield savings accounts, and money market accounts. Cash will not boost your portfolio's growth and you risk losing money in times of high inflation. The argument for holding cash in an investment portfolio is that it reduces volatility and therefore risk.

The first way to decide how to allocate your dollars is by your age. The younger you are, the more risk that you can afford to take with your investments and the older you are, the less risk you can afford to take. This means that if you are young, say in your 20s, you can allocate a much higher percentage of your investments towards more volatile assets such as stocks.

Let's think through this a bit. Say that you are 25 years old and decide that it is time for you to start investing. Your primary focus is to build wealth for yourself later in life, so you decide to invest aggressively. This might mean that you allocate 90% of your available dollars towards stocks and the remaining 10% towards bonds.

This allocation will allow your portfolio the possibility to grow as most of your money is invested in stocks which offer higher returns than bonds. However, the downside to this allocation is that it is riskier since most of your money is in stocks.

If you plan to invest for 30 or 40 years, it is inevitable that the stock market is going to be down at some point during that time. For example, say that the stock market crashed when you turned 35 years old. At this point, you have been investing for 10 years.

Since most of your money is in stocks, your portfolio would take a hit. It can be tempting to panic and sell all your investments. However, since you are young, there is a good chance that the stock market will bounce back.

Since you have another 20 or 30 years to invest, you can afford to take on more risk as you have time to recover from losses. On the flipside, you cannot afford to take on as much risk as you get older because you won't have as much time to recover from losses.

For example, say that you are not 55 years old and only plan to invest for another 10 years. If you keep your allocation to a 90/10 split between stocks and bonds respectively, you might not have enough time to recover from a stock market crash if it happens during your final 10 year investing period.

As you age, you might switch your asset allocation to a more conservative approach. This might look like a 60/40 split between stocks and bonds, respectively. This portfolio will be less volatile than one that had a 90/10 split between stocks and bonds, respectively.

The second way to think through asset allocation is by allocating dollars based upon investing goals. Like your age, the longer you have to reach the goal, the more risk you can afford to take. The less time you have to reach the goal, the less risk you can afford to take.

For example, say that you are 30 years old and plan to invest for your retirement at age 65. Since you have 35 years to reach your goal, you can have a more aggressive asset allocation. This might be a 90/10 split between stocks and bonds, respectively.

This will allow you to build wealth aggressively. As you get closer to retirement, you might switch your allocation to a more conservative 60/40 split. However, if your goal is only a few years away, it is not a good idea to save for it through aggressive asset allocation.

For example, say that you just got engaged and plan to get married in a few years. Since you only have a few years until your goal, it is not a good idea to save for this by allocating most of your dollars towards stocks. If the market crashed, you might not be able to pay for your wedding.

Instead, you could save for your wedding by allocating most of your money to cash through a high yield savings account. This will ensure that you will be able to access the money you need to pay for your wedding in a couple of years.

The third way to think through asset allocation is by assessing your risk tolerance. Risk tolerance is a measure of how much risk you are willing to expose yourself to as you invest. Think of risk tolerance as your emotional response to the fluctuating values of investments.

If you are comfortable taking on more risk in exchange for more reward, you have a high risk tolerance. If the thought of watching your investments go down in value makes you sick to your stomach, you have a low risk tolerance.

If you have a high risk tolerance, you can allocate more of your dollars towards higher risk investments such as stocks. If you have a lower risk tolerance, you can allocate less of your dollars towards higher risk investments and instead try to balance your investments between low and high risk for a more balanced portfolio.

Keep in mind that you can also consider your age and your goals as you look at your risk tolerance. For example, say that you are 25 years old and plan to invest for retirement at age 65. Assume that you have a low risk tolerance.

Even if your risk tolerance is low, you are in the position to handle more risk as you have 40 years to reach your investing goal. You might start your investing journey with an aggressive 90/10 allocation between stocks and bonds respectively, and then switch your allocation to a more conservative approach as you get closer to retirement.

Mike is a 25 year old whose goal is to save for his retirement when he is 65 years old. He has a moderate risk tolerance, which means that he is comfortable taking on some risk, but still wants to have a portfolio that is balanced between risk and reward.

‍If Mike were to purely allocate his availble dollars based upon his risk tolerance, he might allocate 70% towards stocks and 30% towards bonds. This allocation would allow Mike to have a portfolio that has the potential for high returns, while not risking all of the money he has to invest.

However, Mike is smart and understands that his age and his goals also play a part in how he should allocate his available dollars. Even though Mike has a moderate risk tolerance, his young age and 40 year period until reaches retirement allow him to take on more risk.

For this reason, Mike decides to set up an asset allocation with a 80/20 split between stocks and bonds respectively. He understands that this is a higher risk asset allocation, but also understands that he will have enough time to recover from the volatility of his portfolio.

As Mike moves closer to his retirement goal, he might adjust his portfolio allocation to a more conservative approach. This will align with his risk tolerance and will protect him as he will have less time to recover from market volatility as he gets close to his goal.

Amy is a 40 year old whose goal is to save for retirement at age 65. She has a high risk tolerance which means that she is willing to take on high amounts of risk in exchange for the potential of high returns. For sake of example, let's assume that Amy has already been investing for 10 years.

Amy is in a sweet spot. She still has 25 years to reach her goal and has a high risk tolerance. Her age and distance to her goal do not yet negate her risk tolerance. She is in the position where she can still be aggressive with her investments.

For this reason, Amy decides to have a 90/10 asset allocation between stocks and bonds respectively. This portfolio will allow her the potential for higher returns as most of her money is in stocks. As she gets closer to her goal, she might switch to a more conservative asset allocation to protect the money she has.

Steve is 60 years old and wants to save for his daughter's wedding as she recently got engaged. Steve has already been investing for some time and wants to preserve the money he has. For this reason, he has a low risk tolerance.

Steve's daughter is going to get married in a few years. Since there are only a few years to her wedding, and Steve does not want to risk losing the money he currently has, he decides to save for his daughter's wedding in cash. He places money in a high yield savings account to get a more competitive interest rate.

Figuring out your asset allocation is not always easy, especially if you do not have a lot of investing experience. You are trying to figure out what assets to allocate dollars to in order to balance your ability to handle risk with your desire for positive returns. However, there are a couple of things you can do to help you figure out your ideal asset allocation.

Your first option is to use a robo advisor. A robo advisor is a digital financial advisor that uses financial algorithms to help you invest. When you sign up for a robo advisor, the robo advisor will take you through a questionnaire.

During this questionnaire, the robo advisor will ask you questions to gauge your risk tolerance and investing goals. Based upon your answers to these questions, the robo advisor will recommend an asset allocation that aligns with your age, goals, and risk tolerance.

Beyond recommending an ideal asset allocation mix, a robo advisor will also choose investments for you that align with the asset allocation mix. All you have to do is open an investing account and make contributions as the robo advisor handles the rest.

Using a robo advisor can be an easy, low cost solution if you need help figuring out your ideal asset allocation. If you are interested in a robo advisor, you can check out our picks for the best robo advisors.

Although a robo advisor is a good low cost tool that can help you figure out an appropriate asset allocation, it is not a full fledged financial advisor. If you want an expert in your corner, you can opt to work with a human financial advisor.

Not only can a financial advisor help you figure out your asset allocation, but they can also assist in other areas of your financial life. This might include budgeting, insurance planning, education planning, estate planning, and more.

If you are in a position that allows you to work with a financial advisor, it is often worth it. However, make sure to work with a financial advisor that is competent and has your best interest in mind as some financial advisors do not.

By now you should understand that asset allocation is the process of spreading your dollars across different asset classes. However, there is another important investing concept that relates to asset allocation called diversification.

Diversification is the process of spreading your available dollars to different assets within an asset class to lower risk. This may sound confusing so let's look at an example to clarify. Say that the correct asset allocation for you would be an 80/20 split between stocks and bonds, respectively.

This means that 80% of your investments are going to be in stocks and the remaining 20% in bonds. Diversification is the process of picking what stocks and bonds are going to make up that 80/20 split. Have you heard the saying do not put all of your eggs in one basket?

That is what diversification is about. Instead of owning just a single stock and a single bond to make up your asset allocation, you can own lots of stocks and lots of bonds. If you only have a few investments, your entire portfolio is reliant on those few investments.

For example, say that you decide to own Tesla stock and a single corporate bond. Eighty percent of your money is going into Tesla stock and the remaining twenty percent towards bonds. If Tesla goes down or if your bond defaults, your entire portfolio goes down.

Instead, you could diversify your investments. For example, you might own a mix of index and mutual funds to make up your 80% stock allocation and a bond fund to make up your 20% bond allocation. These investment funds get exposed to hundreds of assets all at once.

Even if one of the stocks in an index fund goes down, others that the fund owns might be doing well which can offset the negative effects of that stock. Diversification does not mean you will not lose money, but it can lower your overall risk.

To summarize, imagine it like this. Asset allocation is the process of choosing different baskets (asset classes) and how much money to put in each basket. Diversification is the process of holding a mix of eggs within each of your chosen baskets.   

Up until this point, we have focused on explaining asset allocation by using stocks, bonds, and cash. However, you may be wondering if you can allocate your dollars to other investments besides these. The answer is yes. Asset allocation is simply a process of spreading your dollars across available asset classes.

As long as your asset allocation aligns with your age, goals, and risk tolerance, you can allocate your dollars how you see fit. This might include buying real estate rental properties, owning precious metals such as gold and silver.  

The bottom line is that asset allocation is an investing process in which you spread your available dollars across multiple asset classes. The three main asset classes associated with asset allocation are stocks, bonds, and cash or cash equivalents.

However, you can allocate dollars to other types of investments if it aligns with your age, goals, and risk tolerance. Once you have figured out your asset allocation, it is important to diversify your investments within each asset class to further lower your risk.

At the end of the day, asset allocation comes down to the individual. If you need help figuring out your asset allocation, you can use a robo advisor or work with a financial advisor if you are in the position to do so.