Asset allocation refers to the assignment of a ratio among different asset types in one’s investment portfolio. Here we’ll look at how to set one’s portfolio asset allocation by age and risk tolerance, from young beginners to retirees, including calculations and examples.
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In a hurry? Here are the highlights:
- Asset allocation refers to how different asset classes are proportioned in an investment portfolio, and is determined by one’s investing objectives, time horizon, and risk tolerance.
- Asset allocation is extremely important, more so than security selection, and explains most of a portfolio’s returns and volatility.
- Stocks tend to be riskier than bonds. Holding two uncorrelated assets like stocks and bonds together reduces overall portfolio volatility and risk compared to holding either asset in isolation.
- There are a few simple formulas to calculate asset allocation by age, suitable for young beginners all the way to retirees, and appropriate for multiple risk tolerance levels.
- M1 Finance makes it extremely easy to set, maintain, and rebalance a target asset allocation.
What is Asset Allocation?
Asset allocation simply refers to the specific allotment of different asset types in one’s investment portfolio based on personal risk tolerance, goals, and time horizon. The three main classes can are stocks/equities, fixed income, and cash or cash equivalents. Outside of those, in the context of portfolio diversification, people usually consider gold/metals and REITs to be their own classes too.
Let’s look at why asset allocation is important.
Why is Asset Allocation Important?
These different asset classes behave differently during different market environments, the relationship between two asset classes is called asset correlation. For example, stocks and bonds are held alongside one another because they are usually negatively correlated, meaning when stocks go up, bonds tend to go down, and vice versa. That uncorrelation between assets offers a diversification benefit that helps lower overall portfolio volatility and risk. This concept becomes increasingly important for those with a low tolerance for risk and/or for those nearing, at, or in retirement.
It’s widely accepted that choosing an asset allocation is more important over the long term than the specific selection of assets. That is, choosing what percentage of your portfolio should be in stocks and what percentage should be in bonds is more important – and more impactful – than choosing, for example, between an S&P 500 index fund and a total market index fund. Vanguard actually determined that roughly 88% of a portfolio’s volatility and returns are explained by asset allocation.* Think of asset allocation as the big-picture framework or foundation upon which your portfolio rests, before moving on to the minutiae of selecting specific securities to invest in.
Different investing goals also obviously dictate asset allocation. Given a particular level of risk, asset allocation is the most important factor in achieving an investing objective. An investor who wants to save for a down-payment on a house in 10 years will obviously have a more conservative asset allocation than an investor who is saving for retirement 40 years into the future. Asset allocation is usually colloquially described as a ratio of stocks to fixed income, e.g. 60/40, meaning 60% stocks and 40% bonds. Continuing the example, since bonds tend to be less risky than stocks, the first investor may have an asset allocation of 10/90 stocks/bonds while the second investor may have a much more aggressive allocation of 90/10. We can extend that description to other assets like gold, for example, written as 70/20/10 stocks/bonds/gold, meaning 70% stocks, 20% bonds, and 10% gold.
So what does all this look like in practice? The chart below shows the practical application, importance, and variability of returns of specific asset allocations comprised of two assets – stocks and bonds – from 1926 through 2019. Bars represent the best and worst 1-year returns.
As you can see, asset allocation affects not only risk and expected return, but also reliability of outcome. The chart also illustrates the expected performance of stocks and bonds. Stocks tend to exhibit higher returns, at the cost of greater volatility (variability of return) and risk. Bonds tend to exhibit the opposite – comparatively lower returns but with less risk. Once again, combining uncorrelated assets like these helps preserve returns while reducing overall portfolio volatility and risk. The subsequent percentage of each asset significantly influences the behavior and performance of the portfolio as a whole.
It’s important to keep in mind in all this that past performance does not necessarily indicate future results.
Now that you see why asset allocation is important, let’s look at how risk tolerance affects asset allocation.
Asset Allocation and Risk Tolerance
Remember, one of the major factors in determining one’s asset allocation is personal risk tolerance. Stocks are more risky than bonds. Buying stocks is a bet on the future earnings of companies. Bonds are a contractual obligation for a set payment to the bond holder. Because future corporate earnings – and what the company does with those earnings – are outside the control of the investor, stocks inherently possess greater risk – and thus greater potential reward – than bonds.
So why not just invest in bonds? Again, stocks tend to exhibit higher returns than bonds. Investing solely in bonds may not allow the investor to reach their financial goals based on their specific objective, and unexpected inflation can potentially be damaging to a bond-heavy portfolio. On the flip side, investing solely in stocks maximizes volatility and risk, creating the very real possibility of losing money over the short term. Holding bonds reduces the impact of the risks of holding stocks. Holding stocks reduces the impact of the risks of holding bonds. Such is the beauty of diversification: Depending on time horizon and market behavior, holding two (or more) uncorrelated assets can result in higher returns and lower risk than either asset held in isolation, with a smoother ride.
William Bernstein proposed that an investor can evaluate their risk tolerance based on how they reacted to the Global Financial Crisis of 2008:
- Sold: low risk tolerance
- Held steady: moderate risk tolerance
- Bought more: high risk tolerance
- Bought more and hoped for further declines: very high risk tolerance
Pick a risk level that lets you sleep at night. The behavioral aspect of investing is unfortunately very real and can have significant consequences. Are you going to panic sell if your portfolio value drops by 37% like it did for an S&P 500 index investor in 2008? Also acknowledge and account for cognitive biases such as loss aversion, the principle that humans are generally more sensitive to losses than to gains, suggesting we do more to avoid losses than to acquire gains.
Vanguard has a useful page showing historical returns and risk metrics for different asset allocations that may help your decision process. Once again, remember that same performance seen on that page may not occur in the future.
Asset Allocation Questionnaire
Vanguard has a neat asset allocation questionnaire tool that can be used as a starting point. The questionnaire incorporates time horizon and risk tolerance. You can check it out here. While it may be a useful exercise, it’s still only one piece of the puzzle and doesn’t factor in things like current mood, current market sentiment, external influence etc. Be mindful of these things and try to be as objective as possible.
Asset Allocation by Age Calculation
There are several quick, oft-cited calculations used for dynamic asset allocation of a portfolio of stocks and bonds by age, moving more into bonds as time passes. For the sake of clarity and consistency of discussion, we’re going to assume a retirement age of 60.
- The first and simplest adage is “age in bonds.” A 40-year-old would have 40% in bonds. This may be fitting for an investor with a low tolerance for risk, but is far too conservative in my opinion. In fact, this conventional wisdom that has been repeated ad nauseam goes against the recommended allocations of all the top target date fund managers. This calculation would mean a beginner investor at 20 years old would already have 20% bonds right out of the gate. This would very likely stifle early growth when accumulation is more important at the beginning of the investing horizon.
- Another general rule of thumb is a more aggressive [age minus 20] for bond allocation. This calculation is much more in line with expert recommendations. This means the 40-year-old has 20% in bonds and the young investor has a portfolio of 100% stocks and no bonds at age 20. This also yields the stalwart 60/40 portfolio for a retiree at age 60.
- A more optimal, albeit slightly more complex formula may be something like [(age-40)*2]. This means bonds don’t show up in the portfolio until age 40, allowing for maximum growth while early accumulation is more important, then accelerating the shift to prioritizing capital preservation nearing retirement age. This calculation seems to most closely follow the glide paths of the top target date funds.
Generally speaking, it could be said that these 3 formulas coincide with low, moderate, and high risk tolerances, respectively.
Asset Allocation by Age Chart
I’ve illustrated the 3 formulas above in the chart below:
Asset Allocation Examples
Let’s look at some examples of asset allocations by age.
Using [age minus 20] for bond allocation, a starting age of 20, and a retirement age of 60, a one-size-fits-most allocation would be 80/20. This fits a young investor with a low risk tolerance and a middle-aged investor with a moderate risk tolerance.
Both the [age minus 20] formula and the [(age-40)*2] formula would result in a traditional 60/40 portfolio – considered a near-perfect balance of risk and expected return – for a retiree at age 60.
Several lazy portfolios exemplify nominal asset allocations:
In any case, remember to rebalance regularly (annually or semi-annually is fine) so that your asset allocation stays on target.
Asset Allocation in Retirement
Growth becomes less important near, at, and in retirement in favor of capital preservation. This means minimizing portfolio volatility and risk, such as with the All Weather Portfolio. This is why diversifiers like bonds become more necessary at the end of one’s investing horizon, providing stability and downside protection.
Risk tolerance remains important for retirees. While two of the formulas above yield the famous 60/40 portfolio at a retirement age of 60, Warren Buffett himself has instructed for his wife’s inheritance to be invested ini a 90/10 portfolio. Retirees may also desire to simply use stock dividends and/or bond interest as income, which will influence asset allocation.
The Best Books on Asset Allocation
- Asset Allocation: Balancing Financial Risk by Roger Gibson
- The Intelligent Asset Allocator by William Bernstein
- Rational Expectations: Asset Allocation for Investing Adults by William Bernstein
- All About Asset Allocation by Rick Ferri
Asset allocation is an extremely important foundation for one’s investment portfolio. It is dependent on the investor’s time horizon, goals, and risk tolerance. There are several simple formulas that can be used in helping determine asset allocation by age. Take the time to assess all these factors for yourself. For a hands-off approach, you may be interested in a lazy portfolio or a target date fund.
M1 Finance makes it easier than any other online broker to execute on your intended asset allocation, because your portfolio is visualized in a simple “pie” format, you’re able to input and maintain a specific asset allocation without doing any calculations, and M1 automatically directs new deposits to maintain your target allocations. M1 is perfect for implementing a lazy portfolio, they offer free expert portfolios and target date funds, and they also have zero fees and commissions.
* Vanguard, The Global Case for Strategic Asset Allocation (Wallick et al., 2012).
Disclaimer: While I love diving into investing-related data and playing around with backtests, I am in no way a certified expert. I have no formal financial education. I am not a financial advisor, portfolio manager, or accountant. This is not financial advice, investing advice, or tax advice. The information on this website is for informational and recreational purposes only. Investment products discussed (ETFs, mutual funds, etc.) are for illustrative purposes only. It is not a recommendation to buy, sell, or transact in any of the products mentioned. Do your own due diligence. Read my lengthier disclaimer here.