Asset Allocation
Asset allocation is an investment strategy that divides a portfolio among different asset classes (stocks, bonds, cash) based on an investor's goals, risk tolerance, and time horizon to optimize risk-adjusted returns.
Exam Tip
Asset allocation = dividing portfolio among asset classes. Most important factor in long-term returns. Strategic = long-term targets; Tactical = short-term adjustments.
What is Asset Allocation?
Asset allocation is the process of distributing investments across different asset categories to balance risk and reward according to an investor's specific situation. It is considered one of the most important decisions in portfolio management, often accounting for more than 90% of a portfolio's return variability.
Primary Asset Classes
| Asset Class | Characteristics | Risk/Return |
|---|---|---|
| Stocks (Equities) | Ownership in companies | Highest risk/return potential |
| Bonds (Fixed Income) | Debt securities | Moderate risk/return |
| Cash & Equivalents | Money markets, T-bills | Lowest risk/return |
| Alternative Investments | Real estate, commodities | Varies |
Types of Asset Allocation Strategies
| Strategy | Description | Adjustment Frequency |
|---|---|---|
| Strategic Asset Allocation | Long-term target mix based on goals | Periodic rebalancing |
| Tactical Asset Allocation | Short-term adjustments for opportunities | Active/frequent |
| Dynamic Asset Allocation | Adjusts based on market conditions | Ongoing |
| Constant-Weighting | Maintains fixed percentages | Regular rebalancing |
Sample Allocations by Risk Profile
| Risk Profile | Stocks | Bonds | Cash |
|---|---|---|---|
| Aggressive | 80-90% | 10-15% | 0-5% |
| Moderate | 60-70% | 25-35% | 5-10% |
| Conservative | 30-40% | 50-60% | 10-20% |
Age-Based Rule of Thumb
A common guideline is to subtract your age from 100 (or 110-120 for longer lifespans) to determine stock allocation:
- Age 30: 70-90% stocks
- Age 50: 50-70% stocks
- Age 70: 30-50% stocks
Rebalancing
Rebalancing restores the portfolio to its target allocation when market movements cause drift:
- Calendar-based: Rebalance quarterly or annually
- Threshold-based: Rebalance when allocation drifts 5%+ from target
Key Factors in Asset Allocation
| Factor | Impact |
|---|---|
| Time Horizon | Longer = more equities |
| Risk Tolerance | Lower = more fixed income |
| Financial Goals | Retirement, education, etc. |
| Investment Knowledge | Comfort with complexity |
| Liquidity Needs | May require more cash |
Exam Alert
- Asset allocation is the PRIMARY driver of portfolio returns (more important than individual security selection)
- Diversification across asset classes reduces unsystematic risk
- Strategic allocation = long-term; Tactical allocation = short-term adjustments
- Rebalancing maintains the target risk level
- Modern Portfolio Theory (MPT) is the foundation of asset allocation
Study This Term In
Related Terms
Diversification
GeneralDiversification is an investment strategy that spreads investments across various assets, sectors, or geographic regions to reduce risk without necessarily sacrificing returns.
Rebalancing
SecuritiesRebalancing is the process of periodically adjusting a portfolio back to its target asset allocation by buying underweighted assets and selling overweighted ones. This risk management strategy can be calendar-based (e.g., quarterly or annually) or threshold-based (when allocations drift beyond set limits).