Why Asset Allocation Is Essential for Investing

Amanda Claypool

Writer

When you’re building an investment portfolio one of the most important things you’ll need to do is choose the types of assets you’ll include in it. Will you stick with stocks and bonds or will you venture into the world of commodities and alternative investments?

Determining which assets to invest in is only half the battle. Once you’ve decided on your investment strategy you’ll want to figure out how much of each you’ll include in your portfolio too. This is your asset allocation. Do you want to go all in on Bitcoin or do you want to hedge some of your risk with a few U.S. Treasuries?

Asset allocation is an important way to ensure your investments work for you to help you reach your financial goals. A diversified portfolio can help make sure you don’t overexpose yourself to too much risk and can prevent you from being left high and dry when you’re ready to cash in on your investments.

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  • Asset allocation is a process of determining how to split up the investments in your portfolio.
  • Asset allocation is important because it diversifies your portfolio, mitigating risk
  • To maintain your asset allocation you’ll want to periodically rebalance your portfolio among various asset classes, including stocks, bonds and cash.
  • Asset allocation will vary from person to person and depends on your personal goals, risk tolerance, and the time horizon.

What is asset allocation?

Asset allocation is how you’ll put your investment strategy into action. It determines which assets you’ll buy and how many of each you plan to include in your investment portfolio

A diversified portfolio typically includes assets like stocks, bonds, and cash. Investors can diversify further by including other types of assets like real estate, commodities, or cryptocurrency in the mix. 

Having different types of assets in your portfolio allows you to create diversity, which can help protect your investments from being exposed to too much risk. That’s because different assets react to the market differently. An economic downturn, for example, may cause stock prices to take a sharp dip but because bonds are guaranteed by the government, they might not experience the same decline. 

When you’re thinking about how to allocate your assets, the two most important principles you’ll need to consider are risk tolerance and time horizon.

Risk tolerance

Risk tolerance is your personal appetite for how much risk you’re willing to take on. If you’re looking to speculate on price changes in foreign currencies, for example, you might have a high-risk tolerance. But if you’re nearing retirement and want to protect your nest egg, you might have a low-risk tolerance that will lead you to take a more conservative approach to managing your investments.

Risk tolerance gauges the trade-offs you’ll have to make to earn a reward for your investment. Typically the higher the reward is, the greater the risk. Knowing your personal risk tolerance can help you create an asset allocation that's aligned with your risk appetite.

Here's more about risk tolerance.

Time horizon

You’ll also want to consider the time horizon you’ll be investing in when you allocate the assets in your portfolio. Some investors prefer to buy assets they intend to hold for a long period of time while others buy and sell assets quickly to make a quick buck. Your preference for how long you want to hold an asset and when you expect to start seeing a return on your investment will shape the asset classes you acquire. 

How does asset allocation work?

Asset allocation works by dividing your portfolio between different asset classes. It starts by setting a financial goal and figuring out when you’ll need to generate a return on your investment. From there you can identify the right mix of assets to include in your portfolio to help you achieve your goals that is in line with your expectations for generating a return. Determining the right mix of assets to include in your portfolio will depend on your personal tolerance for risk and the amount of time you plan to invest for.

Asset allocation for high-risk tolerance

Let’s say you’re 22 years old and you just started investing through your company’s 401(k) plan. You are just at the start of your career and won’t need to tap into your retirement savings for several decades. That means your time horizon is long. Because you’re just getting started you don’t have much to lose. You feel OK taking big risks now if that means you’ll have a sizable retirement to cash in on later on.

Someone who fits this description would have a high-risk tolerance and a long time horizon. They might consider allocating 80% to 90% of their portfolio to stocks and the rest to bonds and cash. From there, they can choose how to allocate their stocks further. Let’s say they want to capitalize on economic growth in the market so they allocate 50% of their stocks to large-cap companies and companies in the S&P 500. The rest they allocate to more predictable, stable companies like pharmaceuticals or healthcare.

Over time asset allocation can change. As you get closer to retirement or approach the time when you want to cash out your investment you might opt for a more conservative asset allocation strategy.

Asset allocation for low-risk tolerance

Let’s say you’re 55 years old. You have a sizable portfolio and want to protect what you have. Instead of investing in high-growth stocks, your focus is now on preserving your capital. You might change your asset allocation so that 60% of your portfolio is in stocks while the remaining 40% is in bonds and cash. Within your stock allocation, you might shy away from high-risk tech companies to invest in companies that provide more stability.

Asset allocations can and should change over time as your goals and preferences change. When you’re younger and time is on your side you might conclude you have room to make mistakes. When you’re older and nearing retirement, you don’t want to take on too much risk. You want to avoid high-risk moves that could leave your entire portfolio to lose value during an economic downturn or change drastically due to market conditions.

Hand holding pen with graph, piggy bank, calculator. Guide on understanding what is asset allocation and why is it important

Why asset allocation is important

Asset allocation is important because it diversifies risk while also increasing opportunities for greater rewards. The market constantly changes and not all industries or assets are impacted by it in the same way.

The commodities market illustrates this point well. Commodities include physical goods like oil, coffee, wheat, and corn. A drought affecting the crop yield of coffee, for example, will decrease the supply in the market. This will drive prices up in the short term. This is good for someone trading in coffee, but it might not be good for consumers buying coffee. An investor who invests in both coffee beans and Starbucks would be able to diversify their risk because they are able to capture the price rise in raw coffee beans, mitigating their exposure to waning consumer demand for morning coffee runs.

When you invest in multiple assets across different industries you’re able to spread out your risk more evenly. This can lead to more reliable returns over the long run.

Asset allocation is also important because it can be calibrated to when you’d like to achieve your goals. If you want to retire early you can invest in assets that generate higher returns. If you just want to buy and hold for the long run, you can choose an asset allocation that will provide predictable returns in line with the historical average annual returns of the stock market.

Asset allocation examples

To better illustrate asset allocation, here are a few examples to consider based on age:

22 year old investor40 year old investor55-year-old investor
Risk ToleranceHighMediumLow
Time HorizonSeveral decadesA few decadesOne decade
Stocks90%60%55%
Bonds5%30% 35%
Cash5%10%10%

With age-based asset allocation, an easy rule to follow is to subtract your age from 100. If you’re 40 years old, you subtract that from 100. The difference, 60, is what you’d consider allocating in stocks.

Time is an important variable to consider with asset allocation. If you have a long time horizon you have room to take risks and absorb shocks during a downturn in the market. If you have a shorter time horizon, you don’t have as much room for error.

Related: What is value investing in stocks

How to rebalance your asset allocation

Fortunately, there are things you can do to calibrate your portfolio as your preferences change. Rebalancing is a process of bringing your asset allocation back into alignment with your financial goals. By regularly checking in on how your investments are doing, you’ll likely discover some perform better than others. You can prune out low-performing investments and make new investments that will perform better.

An easy way to rebalance your portfolio is to schedule a time to do it. Set a reminder on your calendar every six months to sit down and review your brokerage account. 

You can also rebalance your portfolio more frequently when there are shifts in the market. For example, let’s say you invested in a tech unicorn that exploded in value. While that’s great for your portfolio, it might mean this single stock now constitutes 80% of your portfolio’s value — more than you’ve allocated for stocks. 

If you’re in your 40s and want stocks to represent 40% of your portfolio you might rebalance by selling some of your unicorn stock and putting the difference toward bonds or cash. You still get to keep the stock in your portfolio but by rebalancing you move some of it into safer assets, protecting it from risk if the stock suddenly goes down.

There isn’t a right or wrong approach to rebalancing but checking in on your portfolio regularly can alert you to changes that need to be made.

Robo advisors

Robo advisors are one way to automate the rebalancing process. They use software and algorithms to manage your investments for you, making regular adjustments to your portfolio. This includes allocating your assets and periodically rebalancing them. By automating the process, robo advisors are an easy solution to passively manage your investments.

The downside of relying on a robo advisor to manage your portfolio and periodically rebalance it is that you don’t have much say in how it’s done. You’ll have access to limited options. While this doesn’t necessarily mean you’ll increase your risk exposure, it does mean you will be limited in your ability to capitalize on gains in the stock market.

Target date funds

Target date funds, also known as lifecycle funds, are a type of mutual fund that automatically shifts its asset allocation based on a time in the future. For example, someone who plans to retire in 2060 can choose a target date fund for that year. Over time a portfolio manager will automatically rebalance the asset allocation so that it increasingly focuses on preserving capital.

The main downside of target date funds is that they aren’t tailored to an individual’s unique financial goals and risk tolerance. They can be an easy way to help you achieve a specific long-term goal, like retirement, but they can limit your growth potential. You’ll only be exposed to assets within the fund and will have limited say over how they are allocated. If you have a high-risk tolerance, this can be a missed opportunity.

Related: Active vs Passive Investing: Which Strategy is best for you

FAQs

What is a good asset allocation?

A good asset allocation will depend on an individual's personal preferences and risk tolerance. If your goal is to use your portfolio to generate income, your asset allocation will be different than someone who wants to capitalize on growth in the market.

These are a few ways to think about asset allocation-based financial goals:

  • Generate income from your portfolio: 70% in bonds and cash, 30% in stocks or other assets
  • Keep your portfolio balanced: 40% in bonds and cash, 60% in stocks or other assets
  • Grow your portfolio: 80% in stocks or other high-growth assets and 20% in bonds and cash

As a general rule of thumb, the closer you are to reaching a major planned financial goal, like retirement, the more conservative you’ll want your asset allocation to be. This will help preserve your capital so you can begin drawing on it without taking unnecessary risks.

What should my asset allocation be for my age? 

As you get older, you’ll want your asset allocation to shift toward more conservative products like bonds. One way to look at it is to use the rule of 100. Subtract your age from 100. The difference represents the percentage you should allocate toward stocks. For example, if you are 30 years old, you’ll want to consider investing 70% of your portfolio in stocks and high-growth securities while keeping 30% in bonds and cash to begin protecting your capital.

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I'm an award-winning lawyer and personal finance expert featured in Inc. Magazine, CNBC, the Today Show, Business Insider and more. My mission is to make personal finance accessible for everyone. As the largest financial influencer in the world, I'm connected to a community of over 20 million followers across TikTok, Instagram, YouTube, Facebook and Twitter. I'm also the host of the podcast Erika Taught Me. You might recognize me from my viral tagline, "I read the fine print so you don't have to!"

I'm a graduate of Georgetown Law, where I founded the Georgetown Law Entrepreneurship Club, and the University of Notre Dame. I discovered my passion for personal finance after realizing I was drowning in over $200,000 of student debt and needed to take action-ultimately paying off my student loans in under 2 years. I then spent years as a corporate lawyer representing Fortune 500 companies, but I quit because I realized I wanted to have an impact; I wanted to help real people and teach them that you can create a financial future for yourself.

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Our aim is to help you make financial decisions with confidence through our objective article content and reviews. Erika.com is part of an affiliate sales network and receives compensation for sending traffic to partner sites, such as MileValue.com. This compensation may impact how and where links appear on this site. This site does not include all financial companies or all available financial offers. This in no way affects our recommendations or article content.

Advertiser Disclosure

Our aim is to help you make financial decisions with confidence through our objective article content and reviews. Erika.com is part of an affiliate sales network and receives compensation for sending traffic to partner sites, such as MileValue.com. This compensation may impact how and where links appear on this site. This site does not include all financial companies or all available financial offers. This in no way affects our recommendations or article content.

Advertiser Disclosure

Our aim is to help you make financial decisions with confidence through our objective article content and reviews. Erika.com is part of an affiliate sales network and receives compensation for sending traffic to partner sites, such as MileValue.com. This compensation may impact how and where links appear on this site. This site does not include all financial companies or all available financial offers. This in no way affects our recommendations or article content.