Financially reviewed by Patrick Flood, CFA.
Asset allocation refers to the 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.
Contents
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 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 down, bonds tend to go up, 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, and equity risk factor diversification may be just as important as asset class diversification.
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.
Moreover, trust that staying disciplined with this framework on your investing journey will allow you to more easily reach your financial objectives and will improve the reliability of the expected outcome (i.e. a decrease in the dispersion of possible outcomes at retirement). You will come out far ahead compared to those who constantly tinker and change their strategy, spinning their wheels jumping to new shiny objects based on whatever the talking heads on TV are saying that week. It’s hard to sell someone a newsletter subscription around the relatively simple, unsexy idea of figuring out a personalized asset allocation, buying index funds, rebalancing annually, and staying the course. The temptation to stray from your asset allocation will be great when you see headlines about market crashes and the past performance of stock picks and sectors, but recognize that this is just survivorship bias and recency bias rearing their ugly heads.
Different investing goals obviously necessitate different asset allocations. 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 far 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 with a short time horizon 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. That is, there is no way for us to know an optimal asset allocation ahead of time, but a fun fact that may be of interest to retirees and/or risk-averse investors is that historically, a 30/70 portfolio (30% stocks, 70% bonds) has produced the greatest risk-adjusted returns.
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.
An entire post could be dedicated to risk tolerance alone. It is highly personal and involves complex psychology from usually-irrational human behavior that we can’t reliably predict ourselves. In investing, unfortunately, the stomach is usually more powerful than the mind.
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. Most investors severely overestimate their tolerance for risk, only realizing their true risk tolerance during a market crash when their portfolio value tanks. The behavioral aspect of investing is unfortunately very real and can have significant consequences. Emotional responses to one’s environment – in this case a financial environment – are hardwired in the human brain. 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 keep in mind that stocks tend to do worse when you are doing worse. That is, your human capital tends to suffer at the same times that your investment capital suffers, so be sure to have an emergency fund established to avoid being forced to sell low and lock in losses just because you need the income during an economic downturn. Lastly, 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 tend to do more to avoid losses than to acquire gains.
Vanguard has a useful page showing historical returns and risk metrics for different asset allocation models that may help your decision process. Once again, remember that same performance seen on that page may not occur in the future.
The best asset allocation is the one that allows you to stay invested. It’s easy to show that a portfolio of 100% stocks has higher expected returns, but if you sell during a market crash due to the extreme volatility, you probably would have been better off with a more conservative 60/40 the entire time.
Larry Swedroe notes: “The discipline to stay the course with an asset allocation is in all likelihood the greatest determinant of returns in the long run, more so than asset allocation itself.”
Trust that you will go through a period of market turmoil where your risk tolerance and subsequent adherence to your asset allocation will be tested.
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 model 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.
Once you’ve decided on an asset allocation between asset types and how much is going to be in stocks, consider then diversifying among your risk factor exposure within stocks, e.g. Size and Value. I explained how and why I do that in my own portfolio here.
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 allocation models 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 allocation models:
- Warren Buffett Portfolio – 90/10
- No Brainer Portfolio – 75/25
- Larry Swedroe Portfolio – 30/70
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. Retirees also shouldn’t shy away from risk factor diversification.
The shorter one’s time horizon, the more important diversification becomes. This has just as much to do with preserving your wealth as it does with a type of risk called sequence risk. Sequence risk refers to the risk of the timing of withdrawals hurting a portfolio’s returns, which is why decreasing the portfolio’s potential variability of annual returns is important in retirement. The greater the volatility of the investment, the greater the sequence risk for the portfolio.
The expected average annualized return of your investment portfolio is not going to happen every single year. The order of annualized returns doesn’t matter during the accumulation phase, so sequence risk isn’t really an issue for young investors, as they have decades to accumulate wealth and they’re typically not making any withdrawals during that phase. That is, young investors can afford to have bad years – and even strings of consecutively bad years – from which their portfolio can later recover.
Retirees don’t have this luxury of waiting, as expenses are constantly happening every month of every year in retirement. During retirement, you can’t recover money you have spent, so a bear market for a retiree in 100% stocks, for example, could be disastrous for the rest of their retirement, as they’ll still need to make those withdrawals to cover expenses during the market downturn that won’t be replenished by any new deposits. Sequence risk is why many people initially planning to retire during the Global Financial Crisis of 2008 had to continue working for a few more years. This sort of timing is out of the control of the investor, but a good retirement plan and subsequent asset allocation will reduce the potential negative impact of this sequence risk. Investors can also mitigate the effects of sequence risk by saving more than they think they need for retirement, and then trying to withdraw comparatively less money during poor performance years.
I delved into the details of sequence risk more here.
Similarly, risk tolerance also remains important for retirees. After you’ve reached your financial objective by meeting your liability-matching portfolio (LMP), you no longer need to be heavily invested in risky assets like stocks. Once you’ve won the game, stop playing. Remember loss aversion; you will regret much more losing, say, half of your portfolio value by staying mostly in stocks than theoretically missing out on the greater gains of stocks compared to fixed income investments. Do the math on your burn rate of capital outflows for liabilities in retirement and make sure your asset allocation is dialed in to match.
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 in a 90/10 portfolio. Retirees may also desire to simply use stock dividends and/or bond interest as income, which will influence asset allocation.
Again, my preferred formula above (number 3) accelerates the shift to bonds after age 40. For a 70-year-old retiree, for example, it yields a risk parity asset allocation of 40/60 stocks/bonds.
Asset Allocation Models By Age
To illustrate this idea of asset allocation shifting as time passes, below is a table showing various hypothetical asset allocations models by age for three hypothetical risk tolerances. This will give you an idea of what yours might look like and how it will change as you get older. As a simplistic example, I’ll use:
Low risk tolerance = “age in bonds”
Medium risk tolerance = “age minus 10”
High risk tolerance = “age minus 20”
Remember, asset allocation is written as a ratio of stocks to bonds, such as 80/20, which means 80% stocks and 20% bonds.
| Age | Low Risk Tolerance | Medium Risk Tolerance | High Risk Tolerance |
|---|---|---|---|
| 20 | 80/20 | 90/10 | 100/0 |
| 30 | 70/30 | 80/20 | 90/10 |
| 40 | 60/40 | 70/30 | 80/20 |
| 50 | 50/50 | 60/40 | 70/30 |
| 60 | 40/60 | 50/50 | 60/40 |
| 70 | 30/70 | 40/60 | 50/50 |
| 80 | 20/80 | 30/70 | 40/60 |
| 90 | 10/90 | 20/80 | 30/70 |
| 100 | 0/100 | 10/90 | 20/80 |
Vanguard has a useful page showing historical returns and risk metrics for different asset allocation models that may help your decision process. Once again, remember that same performance seen on that page may not occur in the future.
The Best Books on Asset Allocation
Interested in reading some books on asset allocation? Some of the best names in the business – Roger Gibson, William Bernstein, and Rick Ferri – have written some:
- 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
Conclusion
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.
References
* 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 otherwise transact in any of the products mentioned. Do your own due diligence. Past performance does not guarantee future returns. Read my lengthier disclaimer here.
This is an excellent source of info. Thank you so much. My question is what is the limit with bond% in your opinion, given our potential lengthier lives in the future? If we go by option 3, (age-40)2, does it just continue on forever? Or, is there a bond limit that we would hit and stay? 60/40 seems optimal in your opinion, so when we hit that at 60, do we just stay or continue to allocate towards bonds until we hit mostly all bonds years after retirement? I worry about very little gains if we’re nearly all bonds. Opinion?
Thank you!
Thanks, Rich! Excellent question. I’ve actually been thinking about how I want to add some verbiage to this post to cover this concept.
When you enter the decumulation phase at retirement, the horizon basically becomes life expectancy, which, as you noted, has been increasing. Asset allocation (and specifically, risk tolerance) is dynamic and becomes highly personal; it can shift based on life events (e.g. having children, incurring large medical bills, etc.) and should be reassessed as these things happen.
I’m of the mind that if you win the game, i.e. accumulating enough to comfortably cover expenses in retirement, stop playing. This could mean going 100% short term treasury bonds. For other people who need to try to keep generating returns in retirement, they’d likely want at least some allocation to stocks, which would be based on the expected return necessary to cover expenses for the horizon of life expectancy.
Inflation risk also enters the conversation, so the retiree would want a shorter bond duration and/or TIPS. Annuities can also be an attractive option for part of the portfolio.
So to answer your question, I don’t think there’s an upper limit, but if the investor wants/needs to do 100% bonds (based on them being risk-averse by necessity or by desire), it doesn’t make much sense for them to not be 100% short treasury bonds, which are considered “risk-free.” Otherwise, I think some small allocation to stocks still makes sense. For example, something like 10/90 stocks to short bonds would be less risky and less volatile than 100% intermediate bonds. Historically, the highest risk-adjusted return has come from an AA around 30/70, but volatility and risk should reliably decrease as the stocks allocation decreases. Looking at it from the other direction, volatility and risk don’t increase much as you slide from 0% stocks (100% short bonds) to 5% or 10% stocks, but expected returns do, as you noted. This idea is illustrated on the Vanguard page of historical performance of different portfolio allocations.
So as usual, it just comes down the investor’s specific needs. A good advisor will perform a comprehensive needs analysis and provide a plan for decumulation that is suitable for the investor based on financial liabilities, values, and risk tolerance. This will usually include simulations (via Monte Carlo) to statistically estimate a range of possible outcomes, from which the most sensible retirement portfolio would be constructed.
Hope that all makes sense and helps answer your question!
Hi John,
Thank you for taking the time to put all of these articles together. For an investing novice with children I find a ton of value in your articles.
A couple of questions for you. I have a 6 & 4 year old with one on the way. I have been putting a few hundred dollars a month in a certificate for the past 3 years but the returns are laughable. I would like to take that money out and start a custodial account with M1. What portfolio would you recommend? Have you built one for this situation? My second question is should I start a portfolio for each child or would I get a better return if I put it all the money into one account? I’m working to “back pay” my 6 year olds account since I started the certificate a few years ago. My goal is to put $100 for each child per month into a portfolio. If I put it all in one account I h e no idea how I would divide it up when they are older.
Thank you in advance for your input!
Ned, that’s awesome! Really glad you’re getting some value out of this stuff!
Depends entirely on time horizon, e.g. are these intended to be used for college at age 18 or for their retirement at age 60? If the latter, I’d do 100% VT and call it a day. If the former, maybe something that minimizes volatility and risk but still gets decent returns like the Golden Butterfly Portfolio.
Returns would be identical whether it’s one account or two, so that just comes down to the time/effort you want to put into setting the accounts up now and then transferring them later. You’re right, might be easier to just do two accounts so you don’t have to sell shares and split one later.
Hope this helps!
Hi John,
Thank you for your response. Yes, my intent is to fund retirement accounts for them. Please excuse my ignorance, but when you say VT are talking about the Vanguard Total World Stock Index Fund ETF? I just googled VT and that is what came up.
Thank you for your recommendation on either doing one account or separate accounts. That clears it up for me. Separate is the way to go for me.
Lastly, John, I want to give a great big thank you! You are doing an incredible work, John. I want you to know that my children and children’s children will be financially better off because of the work you are doing. I share that with you because I hope that in times of reflection, you can have a big smile on your face and great warmth in your heart knowing that people will be financially better off because of what you are doing. You are greatly appreciated. I sincerely thank you!
Ned
Awesome, yep, sorry I should have clarified; yes, Vanguard’s Total World Stock Market fund. It’s about as simple, efficient, and effective as it gets for a young investor with a long time horizon. Globally diversified across stocks and they can say they own over 8,500 stocks in their portfolio.
Wow, Ned, thanks so much for the kind words! They mean more than you know. It’s comments like yours that keep me motivated to do this stuff and remind me why I’m doing it.