What is Asset allocation?

Asset allocation is the decision about how to divide a portfolio between different kinds of investments, called asset classes. The main ones are stocks (shares in companies), bonds (loans to governments or companies that pay interest) and cash. Some investors add gold or Bitcoin. A 60/40 portfolio, for example, keeps 60% in stocks and 40% in bonds. The mix matters because stocks have historically grown faster but swing more, while high-quality bonds tend to move less.

Here is a hypothetical example with round numbers. Say you invest $100,000 with 60% in stocks and 40% in bonds, so $60,000 and $40,000. Now imagine stocks fall by 50% while bonds stay flat. The stock portion drops to $30,000, the bonds remain at $40,000, and the portfolio is worth $70,000, a 30% loss. An all-stock portfolio would have fallen to $50,000, a 50% loss. Recovery differs too. A 50% loss needs a 100% gain to get back to the start, while a 30% loss needs a gain of about 43%, because $70,000 times 1.43 is roughly $100,000.

History shows the same trade-off. Since 1872, a portfolio of 60% US stocks and 40% 10-year Treasuries (US government bonds) returned about 7.9% a year, against 9.4% for stocks alone. Since 2002, using the S&P 500 and long Treasuries rebalanced monthly, 60/40 returned 8.6% a year against 11.1% for stocks, but its worst fall was −28% against −51%. Rebalancing means trading back to the target mix after market moves have shifted it.

A common misunderstanding is that bonds always rise when stocks fall. Their correlation, a measure of whether two assets tend to move together, has shifted over time. US stock–bond correlation was positive in 58% of months since 1875. In 2022, with US inflation at about 9%, long-term Treasuries lost about 30% while the S&P 500 also declined. Allocation is also different from diversification within one asset class. Owning 500 stocks spreads company risk but leaves the portfolio fully exposed to falls in the stock market.

For a private investor building a long-term portfolio, asset allocation is often the most consequential choice, because it shapes both the likely depth of the worst declines and the long-run growth rate. Investors typically weigh how many years they have, when they will need the money and how they react to losses. A mix that can be held through a deep fall without panic selling tends to matter more than squeezing out the last fraction of return.

By Dr. Harry Hamann

What is a good asset allocation by age?
There is no single correct mix. Investors often hold more stocks when they have decades ahead and shift towards bonds as they near the time they need the money, because they have less time to recover from a large fall. Personal tolerance for losses matters as much as age.

What is the difference between asset allocation and diversification?
Asset allocation decides how much goes into each asset class, such as stocks, bonds and cash. Diversification spreads money within and across those classes, for example by owning hundreds of companies rather than a handful.

How often do investors rebalance their asset allocation?
Common approaches are rebalancing on a calendar, such as once a year, or whenever an asset class drifts a set distance from its target. More frequent trading can raise costs and, in taxable accounts, tax bills.