What is Asset Allocation?
Asset allocation is the strategy of dividing your portfolio among different asset classes - stocks, bonds, real estate, and cash. Studies suggest that asset allocation explains over 90% of a portfolio's return variability. A classic 60/40 stock-bond portfolio has historically delivered about 8% annual returns with significantly less volatility than a 100% stock portfolio.
Choosing Your Allocation
Your ideal allocation depends on your time horizon, risk tolerance, and financial goals. A 25-year-old saving for retirement might hold 90% stocks and 10% bonds. A 60-year-old approaching retirement might shift to 50% stocks and 50% bonds. Target-date funds automate this shift, gradually becoming more conservative as the target date approaches.
Key Considerations
The biggest risk in asset allocation is not choosing the wrong mix - it is abandoning your plan during market stress. An investor who switches from 80% stocks to 20% stocks after a crash locks in losses and misses the recovery. Write down your allocation plan and the conditions under which you would change it before a crisis occurs.