What Is Asset Allocation?

Read on for examples and guidelines on asset allocation.

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If you're an investor, filling your portfolio with an appropriate mix of stocks, bonds, cash, real estate and other investments is critical to your financial health, especially during times of economic uncertainty. This mix is commonly referred to as your “asset allocation.” It's definitely not a “one-size-fits-all” proposition. You'll need to set up your asset allocation to reflect your risk tolerance, financial goals, and timeline.

But how do you know know which assets to choose?

Nothing affects your long-term returns more than a good asset allocation plan. Asset allocation can even help mitigate the short-term effects of an inevitable market downturn.

Keep on reading to see what I did on my own retirement plan.

My Own Asset Allocation for Retirement

As I've mentioned in my profile, we have a decent sized nest egg for retirement. The million-dollar question (pun intended), is what assets should we invest in? To me, good asset allocation is the most important thing you can do to ensure long-term success. For this post, I'm not going to go into the technical details of proper asset allocation. That is a whole other discussion, which I may talk about in the future. The purpose of this post is to discuss my current allocation as well as openly discuss the allocation strategy and methods to help improve returns while reducing risk.

For those who wish to understand the technical details, I recommend reading the following books:

I will mention that good asset allocation is based upon the modern portfolio theory (or MPT for short), using indexed based funds, buy-and-hold, and minimizing expenses. During the 2008–2009 crisis, it was said that buy-and-hold was dead. During this period pretty much all assets went down in value: stocks, bonds, commodities, sectors, regions, etc. MPT has its disadvantages and its critics.

Other investment strategies are available but the topic of another discussion. For now it's best to assume, while it won't give you outstanding returns, you'll lose less than most other professional investors during the long run. I will say our allocation is mostly index based, where we do have a percentage (under 20%) that is actively managed by me. If you feel you can do better than the market, it's recommended to allocate no more than 20% for active investing (i.e. picking specific stocks). This means 80% of your investments are kept to the plan of proper asset allocation and buying index based funds.

A little background on our financials. I'm 41 years old, and have 3 children (6 years, 3 years and 25 months old). The asset allocation discussed in this post only includes our retirement accounts. It does not include any of our taxable accounts, our children's 529 accounts, or other assets (i.e. rental property). Each has their own investment objectives and time lines, so in my opinion they should be treated separately. As we approach retirement age (mid 50's and early 60's) I do plan on incorporating more of our taxable investments into our asset allocation. For now they are separate.

My asset allocation is simply meant as a guideline. What may make sense for our risk tolerance, financial objectives, and timeline might not be appropriate for you.

High Level Asset Allocation

Asset Allocation

  • 62% Stocks
  • 25% Bonds
  • 7% Commodities
  • 3% Real Estate (does not include primary residence or rental properties)
  • 3% Cash

Often in financial planning literature they recommend to allocate your bonds based upon your age. Meaning if you are 39 years old, you should allocate approximately 40% to bonds. I've decided to keep the stock allocation based upon our age, but add other investments such as commodities, real estate and some cash, which takes away from the bond allocation. This was based upon a few factors from my research:

  • Commodities and real estate have a much different
  • Commodities and real estate have a higher beta than bonds, so therefore have higher returns for the long run
  • I wanted to have some cash on hand to help in adjustments and for possible purchases when markets are cheap

The allocation will vary slightly over time, but this is the bird's eye view of how the money is invested. As we get older I plan on adjusting our allocation, though stocks will be always at least 50% of our portfolio. Within the high level allocation of stocks and bonds, I sub-divide the allocation into specific sectors.

Depending upon the amount you invest, it may or may not make sense to sub-divide your allocations. The reason is simply because of statistical significance, and in some cases the minimum amounts required to invest. If you have only $10,000 to invest allocating 3% to international bonds means you would invest $300.00. On the other hand, if you have $1,000,000 to invest, $30,000 of international bonds is a decent amount and would generate some returns.

Stock Allocation

Within stocks we divvy up the 62% into:

  • 32% Domestic (52%)
  • 20% Foreign (32%)
  • 10% Emerging Markets (16%)

The percentages in parentheses represent their total allocation within stocks only. A common mistake for U.S. investors is to think the world revolves around us. This is no different than an employee owning too much stock of the company they work for. You have too much invested into one asset class.

Based upon trends, and my opinion, our economic power is decreasing. We represent 27% of the world GDP and that has decreased since 2006. Since this is the case, I have increased my emerging market allocation, to a higher percentage (initially it was 0%) but kept our foreign allocation pretty much the same.

The other aspect is we are truly living in a global economy. It used to be assumed that if America was in a recession, other parts of the world would be thriving during that same period. That's not necessarily true today.

Some studies have shown in the past 20 to 10 years, correlation between international and domestic stocks has increased. This was also shown anecdotally during the 2008-2009 recession. Based upon this, I've decided it's best to spread my stock investments throughout the world.

Mind you, it's almost impossible with today's multinational companies to get completely accurate percentages invested in each of these areas. For example, companies like Coca-Cola have operations in all parts of the world. They, in fact, have business in each of the sectors mentioned. So when owning an S&P 500 fund, most people consider it domestic only. When in fact, over the past 10 years S&P 500 stocks have dramatically increased into international and emerging markets. Like I mention in my Morningstar review, I recommend their X-Ray service to determine if your asset allocation is on target. Not just your bond/stock ratio but also geographic regions and sectors.

Bond Allocation

Most books on asset allocation discuss stocks only. Little is mentioned about bond allocation (I guess because most consider bonds ‘boring'). The questions I've had with bond allocation:

  • How much do you allocate for inflation-based bonds (i.e. TIPS)?
  • How much for corporate bonds or foreign bonds?

William Bernstein in his latest book “The Investor's Manifesto” mentions total bond allocation, but did not go into much detail. He does state when investing in bonds, you should be mostly short-term (i.e. 5-10 years or less). Very little of your asset allocation should be in long-term bonds. Based upon his research, I've setup our bond allocation as follows:

  • 10% U.S. Long Term Bonds.  5–10 year maturity (40%)
  • 10% U.S. Short-Term Bonds. 1–5 year and includes TIPS (40%)
  • 2% U.S. Short-Term Corp Bonds (8%)
  • 3% International Bonds — 3% (12%)

I've recently added a small percentage to international bonds, for the same reason I've increased my stocks into emerging markets.

Commodity Allocation

With commodities, since it's only 7% of the allocation, I currently do not subdivide into other asset classes. At the moment it's comprised of only metals and mining stocks. Mutual funds and ETFs that own things like gold, silver and copper. I currently do not own agriculture, oil, natural gas, or soft commodities. This may be adjusted in the future as the portfolio grows in value, but I don't plan on adjusting the overall 7% allocation.

Real Estate Allocation

About 3% is allocated to real estate, and it is not divided into sub categories. This part of the allocation is invested in REIT funds that cover the entire market. Real estate does not have a strong correlation to stocks or bonds and should be part of your asset allocation. Often times, your personal residence is a big part of your net worth and should be taken into consideration how much to invest in REITs. In our case we have a primary residence and a rental property, so our allocation into real estate is small. I did want some coverage in commercial real estate by owning REITs. I suspect in the next year I will increase this to 5% while decreasing overall stock allocation to 60%. Others may want to increase or decrease their allocation accordingly.

Cash

This allocation may range from 0% to 10%, but no higher. This is somewhat of a misnomer as it's not really cash, but investments in cash-like equivalents. They are short-term instruments that don't vary. Things like money market accounts, short term CDs, etc.

It's meant to keep some reserve for rebalancing. Should a major stock market correction occur, use it to add to stock investments. I'm not really timing the market per se; I'm simply increasing our stock funds when stock corrections of 10 to 20% occur. When these do occur, it becomes more obvious stocks are a bargain and should be used to increase our allocation.

Rebalancing Rules

Common questions I had with MPT: when do you adjust; how often do you adjust?  Based upon some research, and my own opinion I've setup the following:

  • Adjust once or twice a year. This is based upon the size of our portfolio, and how much your portfolio has gotten out of whack.
  • Adjust if the allocation is greater than 3% different than what you are shooting for.
  • Over the years we have somewhat modified our allocation of stock/bond ratio but plan on doing it birthdays of the youngest (that's me). Then only adjust the ratio on birthdays that end in zero (i.e. my soon to be 40th birthday)
  • I sometimes tweak the bond, and stock ratios slightly to increase the amount of cash.

Can You DIY?

Before tackling asset allocation, it's important to understand that your situation is slightly different than anyone else's. So you must first decide on whether you want to DIY your own asset allocation, hire a professional advisor or use a robo advisor service to do it for you at an affordable price.

  • Doing It Yourself – Obviously, handling your own asset allocation allows you to save some money on paying professional fees and expenses. The downside is that you might not be updated enough on the goings-on of the stock market to choose the best diversification strategy for your personal needs.
  • Using a Robo Advisor – As a sort of middle-of-the-road option, a robo advisor (such as Betterment ) will choose a preset allocation strategy for you, based on your risk profile. This allows you to feel confident in your decision without paying a ton of fees.
  • Hiring a Financial Advisor – A professional can help pin point the best allocation for your current situation and investment goals. However, they will be a bit pricier than if you tried tackling it yourself. We recommend checking out Facet Wealth. This is an online firm that connects you with a Certified Financial Planner (CFP) and they can even manage your investments for you.

What Types of Assets Can You Choose From?

The question is: What should you be investing in? A good place to start is with mutual funds and/or ETFs. These funds allow easy diversification without the possibly complicated process of stock picking. For most individuals, ETFs are usually the better choice. Though let’s discuss the differences between the two:

Mutual funds are collections of investments and can be either open-end or closed-end funds. Open-end funds are purchased directly from the fund manager. Their values are determined daily and there isn’t a limit on how many shares are issued. Close-end funds have a limited number of shares and the NAV does not determine the price.

When a mutual fund is sold, the fund has to sell shares to pay the investor. Usually, this will cause a capital gain that must be distributed to shareholders. This mutual fund turnover could result in higher taxes for you.

ETFs, or exchange-traded funds, are made up of units of underlying investments. There are three main types: Exchange Traded Open End Index Mutual Funds, Exchange Traded Unit Investment Trusts and Exchange Traded Grantor Trusts.

  • Exchange Traded Open End Index Mutual Fund: Connected to an index, dividends are reinvested when received, and paid to shareholders quarterly.
  • Exchange Traded Unit Investment Trust: Required to fully replicate the designated index. Dividends aren’t reinvested automatically but they are still paid out quarterly.
  • Exchange Traded Grantor Trust: Investor owns the underlying investments.

Unlike mutual funds, there is no need to sell when an investor wants to redeem their shares. Therefore, capital gains tax isn’t generally a problem due to fund turnover. ETFs also offer the possibility of arbitrage.

For more information about these funds, read Mutual Funds vs. ETFs.

If you are interested in branching outside the “stocks/bonds/mutual funds/ETF” routine, consider alternative investments. Different options you can explore include:

  • P2P investing through Prosper or Lending Club
  • Master Limited Partnership (MLP)
  • Real Estate Investment Trusts (REITs)
  • Ginnie Mae Bonds
  • Commodities – Gold and Silver

A Few Factors to Consider

Here are some important factors to remember when creating your ideal asset allocation strategy:

  1. Humans are emotional – It’s easy to invest when the market is good and really hard to invest when it’s not. When emotions come into play, you are likely to lean too far one way or another because it feels right.
  2. Don't be afraid of what you don't know – By sticking to only stocks and bonds, you could miss out on some great investments. Educate yourself so you don’t miss out on these opportunities.
  3. Investments aren’t scripted – Diversification will not protect your portfolio when all the asset classes tank at the same time as we saw during the financial crisis of 2007-08. That’s a big part of the game that people have problems with.
  4. Avoid too many accounts – Managing multiple accounts can easily confuse you and cause you to forget to diversify one or more of them.
  5. Be careful of diversification overkill – If you are diversifying your assets too much, you are likely missing out on potential gains and paying too much in transaction fees. The key is the balance.
  6. If I haven’t scared you too much yet, check out “6 Reasons Why Diversification Can Be Tricky” for more information on the subject.
  7. One strategy to consider is tactical asset allocation or TAA. TAA involves active portfolio management by rebalancing the percentages of assets based on current economic conditions. For example; let’s say stocks take a plunge. You may want to temporarily rebalance your portfolio to focus on stocks. Why? Buy low, sell high. When everyone is scared, there are deals to be had.

Larry Ludwig

Larry Ludwig was the founder and editor in chief of Investor Junkie. He graduated from Clemson University with a bachelor of science in computers and a minor in business. Back in the ’90s, I helped create some of the first financial websites for firms like Chase, T. Rowe Price, and ING Bank, and later went on to work for Nomura Securities. He’s had a passion for investing since he was 20 years old and has owned multiple businesses for over 20 years. He currently resides in Long Island, New York, with his wife and three children.

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14 Comments

  1. In reply to your comment that, "each [account] has their own investment objectives and time lines, so in my opinion should be treated separately," I'd make the case that you may be able to save some money on taxes by considering your taxable accts and retirement accts as one portfolio. (And then implementing an asset location strategy.)

    1. Hi Mike,
      Thanks for responding.

      This is a topic I really haven't seen discussed in depth anywhere.

      I've thought about that, but could never come to a logical conclusion. My question to you, how do you deal with different objectives? Here are my family's goals with our investments:
      – Retirement
      – Higher Education for Children
      – Money for future investment properties or new businesses

      Each has their own time line and goal, how can you mix them into one, while have then asset allocation for each? Meaning for say investment properties our goal is within the next 5 years to purchase another property, but yet our retirement is 30+ years away. The money for an investment property is in taxable accounts, while the retirement assets are not.

      If they were all for say retirement, I would say sure! But based upon what I've said I don't think so. Convince me otherwise, or state why should be lumped into one?

      1. Certainly it's more difficult when the goals have different timelines. And, to be sure, it *isn't* appropriate for every situation.

        In your situation, I suspect that it has to do with what percentage of your taxable account is intended for this property purchase (and therefore has 5-year timeline). If that's what the whole taxable account is for, then you're right: You have to keep it in something with a level of risk that's appropriate for 5 years.

        But if your taxable account were intended, say, 50% for retirement and 50% for this purchase, then it's a different story.

        The thing that makes asset location strategies work (when appropriate) is that you can hold your short-term investments in your tax-sheltered accounts, if it makes more tax sense to do that. And, in turn, hold long-term investments in your taxable account.

        Then, you can "sell" the short-term investments out of your taxable account (even though they're not there) by doing the following:
        -Sell the long-term investment from your taxable account.
        -Sell the short-term investment from your tax-sheltered account, and buy a long-term investment identical to the one you sold out of your taxable account.

        The net effect is that:
        -you have the same amount of the long-term investment as you did a moment ago,
        -you've liquidated the short-term investment
        -you've liquidated (a portion of) your taxable account.

        …which is the same as if you'd held the short-term investment in your taxable account the whole time, then sold it. The difference being that this has the potential to be more tax-efficient.

        1. Hi Mike,

          Thanks for your response. I can say what I have been doing is making sure tax deferred (403b) or tax free (Roth IRA) investments are fully filled, even if it means taking money out of the current taxable investments. That is our #1 priority, and I assume for others. Basically following the method I list in this post:
          https://investorjunkie.com/2898/tax-efficient-inve

          "The thing that makes asset location strategies work (when appropriate) is that you can hold your short-term investments in your tax-sheltered accounts, if it makes more tax sense to do that. And, in turn, hold long-term investments in your taxable account."

          Explain more what you mean by this? If it's a short term investment how can it be in tax-shelter accounts other than say an ibond or a muni bond fund? Most tax sheltered investments unfortunately are for retirement and if you do take it out early you suffer penalties.

          I understand your logic above and it makes sense to do it this way if you have a mixture.

          1. The idea is that, when you look at the portfolio as a whole, you can effectively liquidate a short-term investment from a taxable account, even if that investment was actually held in a retirement account.

            Simplified example:

            -I have $100,000 in taxable and $100,000 in a Roth.
            -I think I may want to spend $40,000 soon on a home downpayment, so I want to keep that much in short-term treasuries.
            -I've decided that I want a 70/30 stock/bond allocation for the remaining $160k (so $112k of stocks and $48k of bonds).

            There are obviously an almost-infinite number of ways I could split each account up to provide the total 70/30 allocation.

            I'd suggest putting all of the bonds in the Roth (both the ST Treasuries and whatever other bond holdings). So the Roth is $88k bonds, $12k stocks. And all $100k of the taxable is in stocks.

            This way, the tax-inefficient investments (bonds) are tax-sheltered. This is good.

            Then, when the time comes to use that $40k for the home downpayment, I do the following:
            -Sell all $40k of ST Treasuries in my Roth.
            -Sell $40k of stock holdings in taxable.
            -Buy $40k of indentical stock holdings in Roth.

            End result is that my total stock holdings haven't changed, but my ST Treasury holdings have been liquidated–perfectly in keeping with the plan. In effect, I was able to use my Roth space to shelter my (tax-inefficient) investments that I planned to use in the near-term, simply by shifting allocation between accounts as necessary.

          2. Yes agreed.

            It really depends upon how much is in your Roth IRA accounts also, since they can be invested in anything. A decent size of our retirement is tied up in company sponsored retirement plans. So our investment options are much more limited, and hence the reason I'm maxing our Roth IRA money every year. I may also start a company SEP IRA for the same reason.

            I should have educated myself on Roth IRA 10 years ago and started then. Same goes for ibonds as I'm kicking myself now. Live and learn. 🙂

  2. I like the way you explain in detail why you own each asset category. People need to understand asset allocation and why it is so important. You do a great job of this. You also point out that there is a debate going on about "buy and hold". There are certainly long periods of time (decades) where buy and hold destroys wealth. I employ an active asset allocation strategy that has provided me superior returns with a fraction of the risk of the market. You can read more about this strategy at: . Ken Faulkenberry Arbor Investment Planner

  3. Regarding international investing:

    What makes investing in US stocks interesting is that the larger quality companies are already diversifying their earnings overseas since they are finding earnings growth there. So, buying US companies gives you good exposure to international and emerging markets, no extra work is required to get that exposure.

    Still, I have a few pure play international investments that trade as ADBs on the US markets.

  4. Thanks for inviting me to this post. I can see that we are both big Bernstein fans! We also have a similar view regarding the importance of international equities. Your allocation seems very reasonable based on your age. Regarding the bonds, curious as to your duration and yield. For me, most of my bonds were bought when yields were much higher. I’m less inclined to buy bonds now as I’m convinced yields will be rising sooner rather than later (although I have no crystal ball).

    1. Barb,

      Most are bond funds. So “Danger Danger Will Robinson!” The funds are short term duration (sub 10 years). Previously I have been moving into IBonds, CDs and my wife’s 403B has a 3.5% APY fixed income until March 31st 2011.

  5. A few considerations on things I’ve found over the years as a DIY investor (it’s a fascinating arena):
    *Intermediate Treasuries are the prime diversifier for many equity portfolios. The return/risk characteristics tend to maximize portfolio returns, even if other bond categories look more attractive on a side by side compare, which several will. Bernstein didn’t reach this conclusion, and I’m not sure why not, but I’ve only read a couple of his books so far (IIA and 4 Pillars).
    * TIPS should be great protection vs inflation. As you get older, it makes sense to fold these in, when and if your earning power declines or is endangered. See Rick Ferri and Larry Swedroe for two respected voices that like TIPS, but in different amounts. Also, pre – 2009 returns are a bit questionable due to liquidity issues in the market, but that means there’s little useful data, just 6 years worth or so (2009 to present).
    * Gold in 1973/74 was an anomaly that distorts the asset characteristics to make it look far too favorable. Avoid those years in your backtests that include gold funds or where gold influences the price, such as precious metals. The results will be starkly different.
    * I believe that Emerging Market stocks provide a healthy commodity exposure via natural resource extraction industries common in those countries. Adding commodities on top of EM seems to increase volatility in my portfolio with no improvement in returns. YMMV, depending on your portfolio construction.
    * All risk assets move together in a crisis, but in all other time periods, many slices of the market tend to provide diversification benefits (like REITs as you note above), such that risk/return characteristics are superior to a simple 2 or 3 fund portfolio (A simple portfolio has benefits, so this is not to put them down – they are a ‘good’ portfolio and actually optimal for many investors depending on risk profile. I’m just saying that if you are willing to take on a bit more risk (per MPT, but not from a SD or Sharpe perspective) then you may want to consider this approach that is likely to provide a modest but significant boost of returns at very low cost in terms of risk.

  6. One other thing… in retirement, a less volatile portfolio appears to translate to a higher SAFEMAX. While there are all kinds of variation on the 4% rule, this would seem to help all of them. The problem is that Monte Carlo analysis depends on many hidden assumptions, and the same inputs to two differently built simulations can yield very different results. In the end, I think you can’t do retirement on auto-pilot.

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