How To Protect Your Investments Through Asset Allocation

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. You’ll also need to decide how much of each you’ll include in your portfolio. This is your asset allocation.

A diversified portfolio can help ensure 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.

What Is Asset Allocation?

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

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

Having different types of assets in your portfolio gives you 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:

• Your risk tolerance is your personal appetite for how much risk you’re willing to take on. Typically, the higher the risk, the greater the rewards, but this isn't always the case — with high-risk investments, you could also lose money.
• Your time horizon is how long you'll be investing. Some investors prefer to buy assets to hold for a long time, while others buy and sell assets quickly to make a quick buck. The closer you are to retirement, the shorter your time horizon.

For example, if you’re in your 20s and looking to speculate on price changes in foreign currencies, you likely have a high risk tolerance. When you're younger, you have more time to regain any losses.

But if you’re nearing retirement and want to protect your nest egg, you likely have a low risk tolerance and a more conservative approach to your investments. 

RELATED: How Much You Need to Retire: The Ultimate Guide

Why Asset Allocation Is Important

Asset allocation 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.

READ MORE: Long-Term vs. Short-Term Investment Strategies

How To Decide Your Asset Allocation

Start by setting a financial goal and figuring out when you’ll need to generate a return on your investment.

Do you need the money in 40 years or 10 years? Are you saving for retirement in the far future, or do you want to stop working well before retirement age?

From there, you can identify the right mix of assets to help you achieve your goals.

Consider both your personal tolerance for risk and the amount of time you plan to invest.

Asset allocation examples

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 market downturn. If you have a shorter time horizon, you don’t have as much room for error.

Here are a few examples to consider based on age:

	22-year-old investor	40-year-old investor	55-year-old investor
Risk Tolerance	High	Medium	Low
Time Horizon	Several decades	A few decades	One decade
Stocks	90%	60%	55%
Bonds	5%	30%	35%
Cash	5%	10%	10%

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.

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're at the start of your career and won’t need to tap into your retirement savings for several decades.

Because you’re just getting started, you don’t have much to lose. You feel okay taking big risks now if that means you’ll have a sizable retirement to cash in on later.

If this is you, you can have a high risk tolerance since you have a long time horizon. As such, you might consider allocating 80% to 90% of your portfolio to stocks and the rest to bonds and cash.

From there, you can choose how to allocate your stocks further — maybe 50% of your stocks to large-cap companies and companies in the S&P 500, and the rest to more predictable, stable companies like pharmaceuticals or healthcare.

Over time, your asset allocation can change. As you get closer to retirement, you might opt for a more conservative strategy.

RELATED: What Is Growth Investing?

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 more stable companies.

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.

RELATED: What Is Value Investing?

How To Rebalance Your Asset Allocation

As your preferences change over time, there are things you can do to calibrate your portfolio.

Rebalancing is a process of bringing your asset allocation back into alignment with your financial goals. By regularly checking how your investments are doing, you’ll likely discover some perform better than others. You can prune out low-performing investments and pick 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 moving some of your money into safer assets, you're protected if the stock suddenly drops.

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

READ MORE: How Much Time Does It Really Take to Manage Your Investments?

Automate rebalancing with robo-advisors

If you'd rather automate the rebalancing process, you can use robo-advisors.

They use algorithms to manage your investments for you, making regular adjustments to your portfolio. This includes allocating your assets and periodically rebalancing them.

For example, the investing app Webull offers a “Smart Advisor” feature that will rebalance your portfolio for you, to align with the goals you've set in your profile.

The downside of relying on a robo-advisor to manage your portfolio 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.

READ MORE: Robo-Advisors vs. Financial Advisors: Who’s Better for Your Investments?

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 date 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 your 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

TL;DR: Why Asset Allocation Matters

Asset allocation is how you divide your money between different types of investments like stocks, bonds, and cash. It's based on two things: your risk tolerance and how long until you need the money.

A simple rule is to subtract your age from 100 — that's roughly the percentage you should keep in stocks. So if you're 30, consider 70% stocks and 30% bonds and cash.

Rebalance your portfolio every six months or when big market shifts happen to keep your allocation on track. You can do this manually or use robo-advisors or target date funds to automate it.

The closer you get to retirement, the more conservative your allocation should become to protect what you've built.