What Is Asset Allocation?

Asset allocation is the process of deciding how to distribute your investment capital among asset classes such as equities, bonds, real estate, and cash. A landmark 1986 study by Brinson, Hood, and Beebower concluded that approximately 91.5% of portfolio return variability is explained by asset allocation. The combined impact of individual security selection and market timing accounts for less than 10%.

For further reading, practical guides on rebalancing can help clarify when and how to restore a drifted allocation.

In other words, the ratio of equities to bonds matters far more than which individual stocks you pick. The first step in building wealth is deciding on an asset allocation that suits your circumstances.

Major Asset Classes and Their Characteristics

A typical asset allocation is built from four core asset classes. Because each has different risk-return characteristics, combining them reduces overall portfolio risk.

  • Domestic equities: Expected return of 5-7% per year with roughly 18% standard deviation. They track the Japanese economy and carry no currency risk. TOPIX and Nikkei 225 index funds are representative choices.
  • Foreign equities: Expected return of 6-8% per year with roughly 20% standard deviation. They capture global economic growth but are subject to currency fluctuations. MSCI ACWI (All Country World Index) and S&P 500 index funds are popular options.
  • Domestic bonds: Expected return of 0.5-2% per year with roughly 3% standard deviation. Their low volatility makes them a stabilizer within a portfolio. Government and corporate bond index funds fall into this category.
  • Foreign bonds: Expected return of 2-4% per year with roughly 10% standard deviation. They offer higher yields than domestic bonds but add currency and credit risk. Developed-market bond index funds are the standard choice.

Sample Allocations by Age

A common rule of thumb is 'equity percentage = 100 minus your age.' The younger you are, the more risk you can afford, so you hold more equities; as you age, you shift toward bonds to reduce risk. Here are concrete examples.

  • 20s-30s (aggressive): 20% domestic equities + 60% foreign equities + 10% domestic bonds + 10% foreign bonds. An 80% equity allocation targets high growth. With a 20-plus-year horizon, there is ample time to recover from short-term downturns.
  • 40s-50s (balanced): 20% domestic equities + 30% foreign equities + 30% domestic bonds + 20% foreign bonds. A 50% equity allocation balances growth and stability.
  • 60s and beyond (conservative): 10% domestic equities + 15% foreign equities + 50% domestic bonds + 25% foreign bonds. A 25% equity allocation prioritizes capital preservation.

Rebalancing Methods and Frequency

Market movements cause your allocation to drift over time. For instance, if equities rally strongly, an initial 50% equity weighting might swell to 60%. Rebalancing is the process of restoring the original target allocation.

Rebalancing once or twice a year is standard practice. Too frequent and trading costs add up; too infrequent and risk concentrations go unchecked. A practical approach is to review your allocation at a fixed time each year - January or your birthday, for example - and adjust any asset class that has drifted more than 5% from its target. Try our simulator to compare future asset values under different allocation ratios.

Books on age-based allocation strategies can help you learn how to adjust your mix as your life stage changes.