What is asset allocation?

What is asset allocation? 

by Jim Steel, CFA, CFP

As discussed in What is investing?, there are two broad categories (asset classes) of investment vehicles: stocks and bonds. An investor can invest all of their money in either category, or invest some in each, depending on their individual risk preferences. 

Allocating a fixed percentage to each asset category is called asset allocation. The higher your allocation to stocks, the higher your expected rate of return; but also the higher your potential for loss. Conversely, the higher your exposure to bonds, the lower your expected rate of return, and the lower your potential for loss.  

Two main factors that can help an individual determine an appropriate allocation are their willingness and ability to accept risk. Someone may be willing to assume a great deal of risk, but if they need the money for a specific purpose in the short-term (e.g. buying a house or funding an education), they do not have the ability to wait for their investment to recover if markets fall temporarily. Conversely, someone with a very high ability to absorb risk may not have the willingness to do so.  

It is this trade-off between willingness and ability that can determine an appropriate asset allocation. It can be helpful to classify risk on a scale of 0 to 5, where 0 is low and 5 is high. The following portfolio allocations show the various risk levels: 

Portfolio 0:      0% equity; 100% bonds - extremely low risk

Portfolio 1:      20% equity; 80% bonds - very low risk

Portfolio 2:      40% equity; 60% bonds - low risk

Portfolio 3:      60% equity; 40% bonds - low to medium risk

Portfolio 4:      80% equity; 20% bonds - medium to high risk

Portfolio 5:      100% equity; 0% bonds - high risk  

Which portfolio is right for you? The answer, of course, is “it depends”.  The tables below list possible portfolios based on low, moderate and high willingness levels in relation to low, moderate and high ability levels:

Note that not all stock portfolios are created equal. Some stock portfolios may be more risky than others because they include very risky stocks and might use leverage (borrowed money) to amplify gains and losses. Other stock portfolios may consist of only the highest quality companies and not use a leveraging strategy and would be less risky. Therefore, it is important to understand the structure of the fund and the composition of the stocks in your portfolio when selecting an asset allocation. If stocks in the equity portion of your portfolio are on the riskier side, or leverage is employed, then you should consider a less aggressive asset allocation to compensate.

Remember that stocks and bonds are only two broad categories of asset classes. There are other asset classes and sub-classes to consider, but that is a topic for another day.