Step 2: Determining Your Asset Allocation(s)

After you’ve written your investment policy statement, the next step in your investment planning is to determine your asset allocation for your investment accounts.  Asset allocation refers to the percentage or portion of your overall investments that you assign to each asset in your portfolio.  An investor should have different accounts and asset allocation approaches for different goals, based on the amount of risk you can accept and the time horizon for each goal in your investment policy statement.  You should consider your individual circumstances – including your investment time horizon, risk tolerance, and personal life situation – when determining your asset allocation.

When attempting to identify risk tolerance, keep in mind that risk can be defined in different ways.  Many investors define risk more narrowly by equating it with volatility or the likelihood of a major draw-down.  Investors should also, however, consider risk in the context of the overarching goal they are trying to achieve, and measure risk by the likelihood that a particular action (in this case the asset allocation) will achieve that goal.  For example, while bonds are often considered less risky than stocks, a portfolio allocated 100% to bonds is less likely to accumulate enough growth needed to retire comfortably, based on historical returns.  In this sense, a 100% bond portfolio may actually be more risky over the long-term than one that includes a core of U.S. equities, since a bonds-only portfolio is less likely to successfully accomplish the stated goal of building enough wealth to retire comfortably.

While there is no one-size-fits-all approach, a few general rules of thumb may help you determine your asset allocation:

  • A longer-term horizon allows most investors to accept more short term risk in the portfolio, and therefore pursue a more aggressive strategy with a higher allocation to assets with larger draw-downs but also greater potential for returns (i.e. stocks).  If your time horizon is greater than 20 years, you may wish to allocation the vast majority of your investments in equities.  Stocks regularly experience large decreases and volatility, but also have the greatest potential for long-term growth.
  • As your time horizon gets shorter, investors may wish to allocate a greater percentage to fixed-income assets like bonds, which have less potential for capital gains and long-term growth, but have historically experienced smaller draw-downs and less volatility.  Even investors close to retirement, though, may wish to continue allocating some funds to stocks to continue to benefit from capital gains that will help their money last through the retirement years.  Stocks also tend to perform better than bonds in higher inflationary environments, so allocating an entire portfolio to bonds still has its own risks.
  • For short-term savings or emergency funds, short-term U.S. treasuries, money market funds, certificates of deposit, and/or high-yield savings accounts are the appropriate options.  These modest yields for these assets will help limit the amount of lost value due to inflation – which decreases your purchasing power – while also avoiding large dips that would put a portion of your savings at risk in the short-term.

For long- and intermediate-term goals, diversification both within and across asset classes – is important regardless of what approach you take.  Diversification within an asset class can be easily and affordably achieved using ETFs and index funds that track a particular index.  Diversification across assets classes can be achieved by including more than one asset class in your portfolio (e.g. stocks, bonds, real estate, gold, other commodities).  In a diversified portfolio, investors can maintain their desired asset allocation by rebalancing on a regular schedule or based on changes that exceed a particular threshold.

Some examples of asset allocation approaches are provided here for additional assistance.

Key Takeaways:

  • There is no one-size-fits-all asset allocation.  You should consider your individual circumstances – including your investment time horizon, risk tolerance, and personal life situation.
  • Different goals will require different asset allocation strategies based on the above variables.
  • Remember that risk can be defined in different ways, i.e. the risk of not being able to achieve a particular goal versus the more narrow definition that equates risk with volatility or the likelihood that an asset will experience a large draw-down.
  • With the exception of short-term savings and emergency funds, which should focus on less volatile assets with modest yields, diversification within and across asset classes will remain important.