Loading the player...

What is 'Asset Allocation'

Asset allocation is an investment strategy that aims to balance risk and reward by apportioning a portfolio's assets according to an individual's goals, risk tolerance and investment horizon. The three main asset classes - equities, fixed-income, and cash and equivalents - have different levels of risk and return, so each will behave differently over time.

BREAKING DOWN 'Asset Allocation'

There is no simple formula that can find the right asset allocation for every individual. However, the consensus among most financial professionals is that asset allocation is one of the most important decisions that investors make. In other words, the selection of individual securities is secondary to the way that assets are allocated in stocks, bonds, and cash and equivalents, which will be the principal determinants of your investment results.

Investors may use different asset allocations for different objectives. Someone who is saving for a new car in the next year, for example, might invest her car savings fund in a very conservative mix of cash, certificates of deposit (CDs) and short-term bonds. Another individual saving for retirement that may be decades away typically invests the majority of his individual retirement account (IRA) in stocks, since he has a lot of time to ride out the market's short-term fluctuations. Risk tolerance plays a key factor as well. Someone not comfortable investing in stocks may put her money in a more conservative allocation despite a long time horizon.

Age-based Asset Allocation

In general, stocks are recommended for holding periods of five years or longer. Cash and money market accounts are appropriate for objectives less than a year away. Bonds fall somewhere in between. In the past, financial advisors have recommended subtracting an investor's age from 100 to determine how much should be invested in stocks. For example, a 40-year old would be 60% invested in stocks. Variations of the rule recommend subtracting age from 110 or 120 given that the average life expectancy continues to grow. As individuals approach retirement age, portfolios should generally move to a more conservative asset allocation so as to help protect assets that have already been accumulated.

Achieving Asset Allocation Through Life-cycle Funds

Asset-allocation mutual funds, also known as life-cycle, or target-date, funds, are an attempt to provide investors with portfolio structures that address an investor's age, risk appetite and investment objectives with an appropriate apportionment of asset classes. However, critics of this approach point out that arriving at a standardized solution for allocating portfolio assets is problematic because individual investors require individual solutions.

The Vanguard Target Retirement 2030 Fund would be an example of a target-date fund. As of 2018, the fund has a 12-year time horizon until the shareholder expects to reach retirement. As of January 31, 2018, the fund has an allocation of 71% stocks and 29% bonds. Up until 2030, the fund will gradually shift to a more conservative 50/50 mix, reflecting the individual's need for more capital preservation and less risk. In following years, the fund moves to 67% bonds and 33% stocks.

RELATED TERMS
  1. Asset Allocation Fund

    An asset allocation fund is a fund that provides investors with ...
  2. Strategic Asset Allocation

    Strategic asset allocation is a portfolio strategy that involves ...
  3. Portfolio Investment

    A portfolio investment is a passive investment of assets in a ...
  4. Fund Category

    A fund category is a way of differentiating mutual funds according ...
  5. Portfolio

    A portfolio is a grouping of financial assets such as stocks, ...
  6. To Fund

    To fund is a type of target-date retirement fund whose asset ...
Related Articles
  1. Financial Advisor

    An Introduction to Asset Allocation

    A portfolio is only as strong as its asset allocation. To create the right one, investors need to determine their risk tolerance, time horizon and goals.
  2. Financial Advisor

    Asset Allocation vs. Security Selection: The Main Differences

    Both are important to a long-term investment strategy, but asset allocation and security selection have different missions.
  3. Financial Advisor

    The 401(k) Emergency Boomers Need to Address Now

    The asset allocations of Baby Boomers’ 401(k)s are dangerously out of balance. Here's how to remedy that.
  4. Retirement

    Should Asset Allocation Be Based Only on Age?

    There is a better way to determine how your assets should be allocated in your investment portfolio.
  5. Retirement

    3 Best Vanguard Target Retirement Funds

    Learn about three Vanguard target retirement funds that offer broad diversification and automatic rebalancing as investors get close to their retirement ages.
  6. Financial Advisor

    Which Asset Allocation is Best for Clients?

    Modern Portfolio Theory is showing its age. So which asset allocation model is best?
  7. Investing

    The Best Investment Strategies for a Low-Yield Environment

    Our current economic environment is challenging, so you need to have the best investment strategies for your situation. A yearly review is crucial.
  8. Financial Advisor

    Best Performing Target-Date Funds

    Learn about the three best-performing target-date mutual funds (TDFs) from T. Rowe Price, Schwab and Vanguard with target dates around 2040 to 2045.
  9. Financial Advisor

    Target-Date Funds Vs. Risk-Based Funds

    Learn the difference between target-date funds and risk-based funds to determine which would be most appropriate for your retirement portfolio.
  10. Managing Wealth

    Choose Your Own Asset Allocation Adventure

    There are many strategies to help balance your portfolio. Here are a few to get you started.
Hot Definitions
  1. Socially Responsible Investment - SRI

    Socially responsible investing looks for investments that are considered socially conscious because of the nature of the ...
  2. Business Cycle

    The business cycle describes the rise and fall in production output of goods and services in an economy. Business cycles ...
  3. Futures Contract

    An agreement to buy or sell the underlying commodity or asset at a specific price at a future date.
  4. Yield Curve

    A yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but ...
  5. Portfolio

    A portfolio is a grouping of financial assets such as stocks, bonds and cash equivalents, also their mutual, exchange-traded ...
  6. Gross Profit

    Gross profit is the profit a company makes after deducting the costs of making and selling its products, or the costs of ...
Trading Center