When I began my career in the investment services industry more than 20 years ago, I was introduced to the concept of asset allocation. Over the years, I have found better ways to explain it rather than just saying it.
In short, asset allocation is simply the mix of stocks, bonds and cash in a portfolio. According to a famous study by Gary P. Brinson, L. Randolph Hood and Gilbert L. Beebower and their paper “Determinants of Portfolio Performance” published in 1986, more than 90% of a portfolio's performance can be attributed to its asset allocation. The asset allocation of a portfolio is thus its key determinant of performance, risk and volatility over time.
Risk in Your Portfolio
It's a given that all of us would love to double our money tomorrow with no risk, but unfortunately, that happens less than being struck by lightning. Bottom line, everyone wants growth in their portfolio while minimizing its risk, and that is what various asset allocations are historically all about – the ability to get growth while minimizing risk over time.
Ibbotson Associates (now Morningstar) has tracked the performance of stocks, bonds and cash or short-term investments for the majority of domestic investment history. For almost 90 years (1926 -2015), Fidelity Investments has tracked the performance of the combination of these asset classes into four core asset allocations ranging from conservative to aggressive growth. (For more, see: 5 Things to Know About Asset Allocation.)
What can be taken away from these studies is that a conservative allocation of 20% in stocks, 50% in bonds and 30% in cash or short-term investments has historically provided almost 60% of stock market performance with significantly lower risk. One could argue that given a five-year time frame and rebalancing, a conservative allocation has been an extremely low-risk way to invest and gave up less than 2% of value (excluding inflation) over any previous five-year time period from 1926 through 2015.
A balanced portfolio allocation of 50% in stocks, 40% in bonds and 10% in cash or short-term holdings has provided almost 80% of stock market performance with significantly lower risk as well. There is a greater chance of loss with a balanced allocation but one could argue that if one has at least a 10-year time horizon of investment and the discipline to rebalance their account, the chance of loss diminishes significantly.
Determining Asset Allocation
To determine an initial asset allocation for your portfolio, you might visit the internet and search for an investment profile questionnaire. There are many free questionnaires available on the internet that can point you to an appropriate target mix. Before investing, be sure to review the historical performance of the mix you are directed too and make sure you are comfortable with the risk and volatility associated with it.
Once built, it is important to rebalance the portfolio back to its original mix occasionally. At a minimum, consider rebalancing at least once a year or when an asset class deviates by 5% or more from the original allocation.
Most investment services firms would have you believe that investing is an extremely intricate and complex process. But it becomes relatively simple when you understand that asset allocation (selection and rebalancing) accounts for more than 90% of the investment process. (For more from this author, see: Cut Your Investment Fees to Be a Wall Street Deadbeat.)