Asset Allocation

Every portfolio has an asset allocation, whether you chose it or not: the share of your money in each asset class. The three major classes are Stocks, which offer the most growth and the deepest drops; Bonds, which pay interest and usually swing less; and cash equivalents such as savings deposits, money market funds and Treasury bills, which are the most stable but can struggle to keep up with inflation. Some investors add real estate, commodities or other assets.

The SEC’s investor education office explains the logic: historically, the returns of the three major asset categories have not moved up and down at the same time, so conditions that hurt one often leave another holding steady. Holding more than one class lowers the chance of a large loss and smooths the ride, at the cost of some growth in the best years.

The mix matters more than the fund names. Two people holding the same low-cost index funds can have very different experiences if one holds 90% stocks and the other 40%.

The SEC calls choosing an allocation a very personal decision that depends largely on your time horizon and your ability to tolerate risk. In practice, four questions do most of the work, and each goal can get its own answer. A down payment due in two years and a retirement fund you will draw on for 30 years should not share a mix, even if both sit at the same brokerage.

Age-based rules of thumb, which draw a straight-line glide path from your birthday, are a starting point at best. They ignore how much you have saved, how much you need and what other income you will have.

Once you pick targets, you need a method for keeping them. A strategic allocation sets long-term percentages, such as 70% stocks and 30% bonds, and returns to them through periodic Rebalancing. A glide-path allocation schedules the targets to change, usually toward bonds as retirement approaches. A tactical allocation shifts the mix on a view of where markets are heading, which demands forecasting skill few investors have. The SEC observes that savvy investors typically do not change their allocation because one asset class has been doing well.

All-in-one funds can do the job for you. A target-date fund follows its own glide path, and a balanced fund holds a fixed mix such as a 60/40 portfolio. Do-it-yourself investors often build the mix from a few index funds, as in a three-fund portfolio. In retirement, a bucket strategy divides the same allocation by when the money will be spent.

Whichever method you use, change the targets when your goals, time horizon, risk tolerance or finances change, not because of last quarter’s returns.

These three ideas are often blurred, but they answer different questions. Asset allocation decides how much goes into each asset class. Diversification decides how widely you spread money across and within those classes: among many companies, industries, countries and bond issuers. Asset location decides which account holds each asset, for example keeping taxable bond interest inside a 401(k) or IRA and tax-efficient stock index funds in a taxable account, which can lower your tax bill without changing the household mix.

An allocation does not automatically diversify you. The SEC gives two allocations that can be reasonable: a 25-year-old saving for retirement entirely in stocks, and a family saving for a house down payment entirely in cash. Both are deliberate choices, yet neither spreads risk across asset classes, and an all-stock allocation built from a handful of individual stocks would not be diversified within its one class either.

Most allocation problems are not about choosing 60% versus 65% stocks. They come from measuring the mix wrongly, abandoning it at the wrong moment or never revisiting it as your life changes. Two questions make a good test. Can you state your household’s stock, bond and cash percentages across every account? Would you still hold them after a 30% fall in stock prices? If either answer is no, look for these mistakes.