If you ask most professional investors what the single most important investment decision is, they will not say which stocks to buy. They will say asset allocation.
Asset allocation is how you divide your portfolio among different asset classes. And research consistently shows it determines about 90% of your long-term investment returns.
What Asset Allocation Means
Asset allocation is the percentage split between different types of investments in your portfolio:
- Stocks (equities): Higher potential returns, higher volatility
- Bonds (fixed income): Lower returns, lower volatility, regular income
- Cash and cash equivalents: Lowest returns, highest stability
A common example: 60% stocks, 30% bonds, 10% cash. This is sometimes called a "60/40 portfolio."
Why It Matters More Than Stock Picking
A landmark study by Brinson, Hood, and Beebower found that asset allocation explained about 91.5% of the variation in portfolio returns over time. Individual stock selection and market timing explained less than 10%.
In other words: whether you put 80% in stocks or 40% in stocks matters far more than which specific stocks you pick within that allocation.
How to Choose Your Allocation
Your allocation should be based on:
Time horizon. The longer you have until you need the money, the more risk you can generally take. A 25-year-old saving for retirement can tolerate more stock exposure than a 60-year-old five years from retirement.
Risk tolerance. How much volatility can you stomach? An 80% stock portfolio might drop 40% in a bad year. Can you hold through that?
Financial goals. Are you building long-term wealth, saving for a house in 5 years, or generating retirement income? Each goal suggests a different allocation.
Common Allocations by Age
These are general starting points, not rules:
- Age 20-30: 80-90% stocks, 10-20% bonds
- Age 30-40: 70-80% stocks, 20-30% bonds
- Age 40-50: 60-70% stocks, 30-40% bonds
- Age 50-60: 50-60% stocks, 40-50% bonds
- Age 60+: 40-50% stocks, 50-60% bonds
The old rule of thumb was "subtract your age from 110 to get your stock percentage." It is a rough guide, not a precise formula.
Rebalancing
Over time, your allocation drifts. If stocks have a great year, they might grow from 60% to 70% of your portfolio. Rebalancing means selling some stocks and buying bonds to return to your target allocation.
Most investors rebalance once or twice a year, or whenever their allocation drifts more than 5% from target.
The Bottom Line
Asset allocation is the decision that matters most. Get it right for your situation, and the rest of your investing decisions become much simpler.
The Progressive Trailblazer includes portfolio analysis tools to help you understand your concentration and exposure. Educational only. Not financial advice.