What Is Asset Allocation and How to Properly Do It - SmartAsset

Asset allocation is the mix of investments you choose for your investment portfolio. Picking the right mix is key to maximizing returns and minimizing risk as you invest. If you don’t get the mix right, you could miss out on some opportunities to earn returns. Or, you could take on too much risk and end up losing your savings without enough time left to earn it back.

This guide will take you through what asset allocation is, the different ways you can allocate your assets and how your asset allocation is likely to change with age. It will also explain how working with a financial advisor can help you when it comes to asset allocation.

Asset Allocation Defined

Strictly defined, asset allocation is exactly what is sounds like: how you allocate your assets when investing. Specifically, it is about how you allocate your assets among three major investment types: stocks, bonds and cash.

Stocks are small portions of companies purchased for a price determined by the market. You can buy stock in many of the biggest companies in the world, like Apple, Microsoft and General Motors. You can also buy stock in smaller companies that have chosen to go public. Stock prices fluctuate throughout the day. When investing in stocks, the general idea is to sell the stock for a higher price than you bought it, creating return on investment.

Bonds are a certificate of debt you purchase. Companies, governments and municipalities sell bonds. Bonds pay back with interest at a certain point, known as the maturity date. They generally have less upside than stocks, but are also less risky.

Cash is just that: cold, hard cash that you can access at any time, without having to make another financial maneuver. It can be stored in a traditional savings account or in a money market account.

Typical Asset Allocation Mixes

There are, generally speaking, five basic asset allocation models you can follow:

Very conservative: 20% stocks, 50% bonds, 30% cash
Conservative: 45% stocks, 40% bonds, 15% cash
Moderate: 65% stocks, 30% bonds, 5% cash
Aggressive: 80% stocks, 15% bonds, 5% cash
Very Aggressive: 90% stocks, 5% bonds, 5% cash

The more aggressive you are, the more you are investing in stocks, which have the potential to produce a big return but also carry a greater risk of loss. Bonds, meanwhile, suit more conservative asset allocation strategies because while they don’t have as a big of an upside, they have guaranteed income.

Why Asset Allocation Is Important

If you ask most financial advisors, they’ll tell you that the key to a successful portfolio is diversification. You don’t want to have all of your eggs in one basket so that if one investment fails, your entire financial life doesn’t come crumbling down.

Thinking about asset allocation is part of building a diverse portfolio. If you have a predetermined mix of investment types, you avoid putting too much money into any one investment. Furthermore, splitting up your assets into different classes allows you to both maximize returns through smart investments in stocks and protect the assets you have through finding bond investments that are low-risk while still providing some return.

How Asset Allocation Changes with Age

The asset allocation model you use when you are 25 and working at your first job is certainly going to be different from the one you use when you’re 55 and starting to think about retirement. When you are younger, you are more likely to want to use an aggressive or very aggressive asset allocation model that’s focused on stocks and creating strong return on investment. When you are older, you will likely prefer a conservative or very conservative strategy. Focusing your investments on bonds at that age protects your retirement fund and creates an income stream that you can rely on once you have stopped working. In short, your risk tolerance is higher when you are younger because you have more time to make up potential losses.

Age isn’t the only thing that goes into determining your optimal asset allocation though. You’ll also want to consider your time horizon and specific investing goals. For instance, if you have a big expense coming up — say you are considering buying a home — you might get more aggressive with your asset allocation to try to gain capital to make that purchase. Furthermore, the arc of your career may not be the same as everyone. If you want to work until age 75, your asset allocation at age 55 would be different from someone who plans to retire at age 62.

Hiring a Financial Advisor to Help with Asset Allocation

Asset allocation, like many investing topics, can be confusing. You might not be able to build your portfolio yourself, especially if you have a lot of money or are looking to set up a fairly complex series of accounts. It probably makes sense to find a financial advisor who can help you create the right asset mix for you.

This could go a number of ways. Some financial advisors will work with you to create a custom portfolio according to your exact specifications. Others will offer you a menu of model portfolios, each with a different asset allocation goal, from which you can choose. Sometimes within those asset allocation buckets there will be different options. For instance, there might be an aggressive portfolio that focuses on tech stocks, and one that focuses on the energy sector.

Make sure your financial advisor presents you with all of your options, and make sure to ask your financial advisor about how your asset allocation model might change as you get older.

The Bottom Line

Asset allocation is an important part of how you construct your portfolio. It determines how much risk you are taking on, and what potential income your portfolio will generate. There are a number of asset allocation models. Your financial goals and stage in life will determine which asset allocation is right for you.

Investing Tips

Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Take into account capital gains taxes when you’re thinking about how much money you’ll make off of your investments. SmartAsset’s capital gains tax calculator can help you figure out how taxes will impact the money you make from selling stocks.