Asset allocation helps you invest your money intelligently and achieve your financial goals. This strategy involves dividing your portfolio among asset classes to reduce risk exposure. But how do you determine the best asset allocation for your situation? Although there's no one-size-fits-all answer, investors often adjust their asset allocation by age. This article explains asset allocation, its significance and how to break it down by age.
What is Asset Allocation?
Asset allocation is the strategy of allocating your investment portfolio among asset classes with various risk and return characteristics. The main purpose of asset allocation is to diversify your portfolio and optimize your risk-adjusted returns. Diversification means spreading your investments across various uncorrelated asset classes. This way, you can reduce the overall volatility of your portfolio and try to protect against losing too much money when one asset class performs poorly.
Determining Asset Allocation
Your portfolio's optimal mix of asset classes depends on your risk tolerance, time horizon and financial goals.
- Risk tolerance: Managing your risk tolerance refers to deciding how much uncertainty you are willing to accept.in your investments. Risk tolerance can be individual and reflects your personality, preferences and emotions. It can change over time as your life circumstances change. Some prefer higher risks for higher returns, while others prioritize lower risks and lower returns.
- Time horizon: The time horizon is the length of time you plan to hold your investments before you need to use them for a specific purpose. Your financial goals and restrictions determine your time horizon as an investor. The length of time varies depending on your age, income, expenses and objectives. For instance, those saving for retirement usually have a longer time horizon than those saving for a vacation or car.
- Financial goals: Financial goals reflect your values and aspirations as an investor. They are the outcomes you want to achieve through your investments and can be more or less ambitious depending on your needs and aspirations. Whether you hope to retire early, travel the world or leave a legacy for your family, it's important to define clear and actionable goals that align with your vision for the future.
Importance of Asset Allocation
Proper asset allocation can significantly impact your investment performance and help you reach your financial goals. A study by Brinson found that asset allocation accounts for approximately 90% of the variation in portfolio returns over time. This discovery emphasizes the importance of selecting the right mix of asset classes over individual securities within each class.
You can optimize your risk-adjusted returns by diversifying your portfolio across asset classes with different risk and return characteristics. Risk-adjusted returns measure the return per unit of risk, with higher risk-adjusted returns indicating better portfolio performance. Asset allocation can also reduce the impact of market fluctuations and prevent emotional investing. A balanced portfolio that fits your risk tolerance, time horizon and financial objectives can reduce portfolio volatility and avoid panic buying or selling during market shifts.
Breaking Down Asset Allocation By Age
As you navigate life's various stages, your financial situation, responsibilities and goals may shift, necessitating changes in your asset allocation strategy. Although there is no definitive rule for allocating your assets by age, here are some general principles that can inform your investment decisions. Keep in mind that the sample portfolios are for reference only and can vary based on your personal needs.
Young Adulthood (18-30 years)
During young adulthood, you typically have a longer time horizon and more aggressive financial goals. You may be starting a career, paying off student loans, saving for a house or beginning a family. With more flexibility and mobility in your lifestyle and career choices, this stage is an optimal time to focus on building wealth and investing for growth.
To invest for the long-term, you may allocate a significant portion of the portfolio to growth-oriented or higher risk investments, such as stocks and alternatives such as real estate or commodities. While these asset classes may offer higher returns over the long term, they are also more volatile and have higher risks. Diversifying the stock portfolio across different sectors, industries, regions and market capitalizations can help reduce exposure to any single segment of the market. A sample portfolio might consist of an 80% allocation to stocks and 20% to bonds, alternatives and cash to gain exposure to the stock market's growth potential.
Early to Mid-Career (30-45 years)
As you progress in your career, you may find yourself shouldering more financial responsibilities and striving towards new goals. This situation means you'll need to balance building and preserving your wealth. A reasonable approach is to invest in a mix of growth-oriented stocks, fixed-income options like bonds and certificates of deposit (CDs) and alternative investments such as commodities or private equity.
Stocks offer the potential for high returns over the long term, while fixed-income investments provide more stability and diversification. Alternative investments offer the chance for quick returns but come with higher risks. To maintain a balanced portfolio, consider putting 60% in stocks, 30% in bonds and cash and 10% in alternative investments. Diversifying your bond portfolio can help reduce interest rates and mitigate credit risks.
Late-Career (45-60 years)
As you near retirement or are already in your late career, your financial goals and priorities may shift towards preserving your wealth and investing for reliable income. This development means allocating a smaller portion of your portfolio to higher risk, growth-oriented investments like stocks and a larger portion to fixed-income and alternative investments that provide steady income and capital preservation. Consider allocating 40% of your portfolio to stocks, 60% to bonds, alternatives and cash.
Retirement (60+ years)
As a retiree, your financial goals, risk tolerance and time horizon may differ significantly from those in other age groups. You could rely on retirement savings, pension or social security to cover expenses like healthcare, travel or leisure or to leave a legacy for your family or charity. Also, you may have fewer options and resources with regard to lifestyle and career choices. To balance growth and income, you can maintain a portfolio with a small portion allocated to stocks and growth-oriented investments and a larger portion to fixed-income and alternative investments for consistent income and capital preservation.
A sample portfolio might allocate 20% to stocks and 80% to bonds, alternatives and cash. Diversifying income sources across dividends, interest, rents, royalties or annuities can also be beneficial.
General Considerations for Asset Allocation
Life events such as marriage, divorce, illness and retirement can change your financial goals, risk tolerance and time horizon. To maintain your ideal asset allocation and risk level, you should monitor your investments' performance and progress, comparing them with your objectives and benchmarks. Periodic rebalancing may be necessary to sell assets that have increased in value and buy those that have decreased in value. Diversifying your investments across different asset classes with low or negative correlations can help reduce overall risk and volatility while enhancing risk-adjusted returns.
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Mastering Asset Allocation Across Life's Stages
Asset allocation is a crucial strategy for achieving financial goals by diversifying your investment portfolio across asset classes. Your optimal asset allocation depends on your risk tolerance, time horizon and financial goals. As you progress through life's stages, you should adjust your asset allocation to align with your changing circumstances and objectives. A balanced and diversified portfolio can help you manage risk and achieve your financial aspirations regardless of your life stage.
Frequently Asked Questions
What is the 12-20-80 asset allocation rule?
The 12-20-80 asset allocation rule is a guideline that suggests an investor allocate 12% of their portfolio to risk-free assets, 20% to fixed-income assets and 80% to equity assets.
What should a 50-year-old investor’s asset allocation be?
A 50-year-old’s asset allocation should be more conservative than a younger investor’s. A general rule of thumb is to allocate around 50% to equities and the rest to fixed income and cash.
What should a 25-year-old investor’s asset allocation be?
A 25-year-old has a longer investment horizon, so they can afford to take on more risk. A standard recommendation is to allocate around 80% to equities and the rest to fixed income and cash.
About Anna Yen
Anna Yen, CFA is an investment writer with over two decades of professional finance and writing experience in roles within JPMorgan and UBS derivatives, asset management, crypto, and Family Money Map. She specializes in writing about investment topics ranging from traditional asset classes and derivatives to alternatives like cryptocurrency and real estate. Her work has been published on sites like Quicken and the crypto exchange Bybit.