What is asset allocation? Definition, types, and examples

Where should you invest your money? Are stocks and bonds right for you, or is real estate a better option?

What percentage of your investment portfolio should you keep in cash? And how should the answer to these questions change as your life situation develops?

The answer to these questions depends on your asset allocation strategy.

In this guide, we’ll explain what asset allocation is, the role it plays in improving investment accounts, and the most common asset allocation strategies investors employ.

What is asset allocation? 

Asset allocation is the process of distributing investments across different asset classes, such as stocks, bonds, and cash.

The idea is to balance risk and reward in accordance with your financial goals, time horizon, and tolerance for risk.

Effective asset allocation also protects you against volatility and changing economic conditions, helping you maximize returns while managing and minimizing risk.

The key asset classes found in different asset mixes include:

• Equities (stocks)
• Fixed income (bonds)
• Cash and cash equivalents
• Real estate and REITs (real estate investment trusts
• Commodities (gold, oil, etc.)
• Alternative investments such as private equity, hedge funds, and cryptocurrencies 

The importance of asset allocation in investment management 

Effective asset allocation is a crucial part of investment management. Your asset allocation determines the overall risk and return profile of your portfolio and ensures your investments align with your financial goals and risk tolerance.

Asset allocation has a huge impact on risk and return. Stocks, for example, tend to be a high-risk, high-return potential investment. Bonds, on the other hand, offer lower risk but provide moderate returns.

Your decision on how much to invest in each has a large influence on the risks you take and the potential return you can earn.

Here are a few examples of how different allocations impact risk and return:

• Aggressive allocation (e.g., 80% stocks, 20% bonds): Higher returns but higher volatility.
• Balanced allocation (e.g., 50% stocks, 40% bonds, 10% cash): Moderate risk with steady growth.
• Conservative allocation (e.g., 20% stocks, 70% bonds, 10% cash): Lower returns but greater capital preservation.

The role of asset allocation in achieving financial goals 

A well-structured asset allocation strategy helps investors meet their short-term and long-term financial goals. These may include:

• Retirement planning: Younger investors can afford higher stock exposure, which should be shifted toward bonds and other income-generating assets to reduce risk as retirement nears.
• Wealth preservation and capital protection: Investors focused on capital preservation allocate more to bonds, cash, and real estate.
• Income generation: Retirees or those seeking passive income might prefer dividend-paying stocks, REITs, and bonds.

Without proper asset allocation, an investor might take too much risk (leading to large losses) or too little risk (leading to insufficient returns to meet goals).

Consequences of poor asset allocation decisions 

Here are some common pitfalls with examples:

• Overconcentration in one asset class: Investing heavily in tech stocks in 2000 or cryptocurrency in 2021 would have exposed investors to extreme volatility.
• Misjuding risk tolerance: An investor allocates 90% to stocks but panics during a market downturn and sells at a loss.
• Ignoring inflation and growth needs: An investor keeping all funds in cash or low-yield bonds may reduce future wealth as a consequence of inflation.
• Poor timing and market speculation. Switching between asset classes too frequently based on short-term trends creates higher transaction costs and often increases losses from mistimed market moves.

Examples of asset allocation approaches 

Here are a few common examples of approaches that investors take when allocating their assets.

Strategic asset allocation

Strategic asset allocation is a long-term investment approach where a fixed percentage of assets is allocated to different asset classes based on an investor’s risk tolerance, goals, and time horizon.

The portfolio must be rebalanced periodically to maintain the original allocation, as marketing fluctuations can increase or decrease the allocation of given assets, particularly equities,

For instance, a moderate-risk investor might set a strategic asset allocation of:

• 60% stocks (growth)
• 30% bonds (stability)
• 10% cash (liquidity) 

If market fluctuations cause stocks to grow to 70% and bonds to shrink to 20%, the investor sells stocks and buys bonds to restore the original 60/30/10 ratio.

Tactical asset allocation

Tactical asset allocation is a more active approach where asset allocation is adjusted more regularly based on short-term market opportunities.

With this approach, investors temporarily shift allocations to take advantage of economic trends or undervalued asset classes.

For example, say an investor with a 60/40 stock-bond allocation believes tech stocks will outperform in the next year. They increase stock exposure to 70% by reducing bonds to 30%, and then rebalance back to 60/40 once they believe that tech stocks have peaked.

Age-based asset allocation

Age-based asset allocation is a customized strategy where asset allocation changes as the investor ages to balance risk and security.

The broad idea is that younger investors can afford to take on more risk (more stocks), while older investors shift to safer assets (more bonds and cash).

An age-based allocation plan might look like:

• Age 25: 80% stocks, 15% bonds, 5% cash
• Age 50: 60% stocks, 30% bonds, 10% cash
• Age 65: 30% stocks, 50% bonds, 20% cash

Lifecycle funds

Lifecycle funds are similar to age-based asset allocation.

They are a pre-set mutual fund or ETF that automatically adjusts its asset allocation based on a target retirement date.

Investors buy into specific funds based on their target date.

For instance, a "2045 Target-Date Fund" might hold:

• Today: 90% stocks, 10% bonds
• In 2045: 40% stocks, 50% bonds, 10% cash

What is Barbell asset allocation?

Barbell asset allocation is another approach that seeks to balance risk with safety by investing in both extremes.

The portfolio is divided between ultra-safe and high-risk assets, with little to no middle-ground assets.

For instance, an investor might allocate as such:

• 50% in high-risk stocks (e.g., tech startups, crypto)
• 50% in ultra-safe assets (e.g., Treasury bonds, cash)
• No investments in medium-risk assets like blue-chip stocks or corporate bonds.

Factors influencing asset allocation decisions 

What impacts an investor’s decision to use one asset allocation method or another?

Here are the five main factors you should consider when choosing an asset allocation strategy.

1. Individual risk tolerance 

If you have a higher risk tolerance, invest more in stocks for growth. 

If you have a lower risk tolerance, tend more toward bonds and cash for stability. 

2. Investment objectives and income needs

If your goal is wealth growth, go for a higher equity allocation.

If steady income is your goal, allocate more toward bonds, REITs, and dividend stocks.

If capital and net worth preservation is most important, side with a conservative allocation strategy to minimise risk.

3. Liquidity requirements 

If you’re investing for the long term, then you can afford to allocate more to illiquid assets like real estate and private equity.

If, however, you need quick access to cash, hold liquid assets like cash or money market funds.

4. Market conditions and economic indicators 

Many investors apply these strategies:

1. Shift to bonds, defensive stocks, and gold during recessions
2. Increase exposure to equities for growth during bull markets
3. Consider real estate, commodities, and inflation-protected bonds during periods of high inflation 

5. Time horizon and life stages

Younger investors with a longer term investment horizon can focus more on high-growth stocks, while those approaching retirement should shift toward bonds and income-generating assets.

If you’re retired, a more conservative allocation for capital protection might be a better move.

Which asset allocation strategy is right for you? 

A well-structured asset allocation strategy is key to balancing risk and return, aligning investments with financial goals, and adapting to life stages. 

By diversifying across asset classes and adjusting allocations as needed, investors can optimize returns, manage risk, and build long-term financial stability in changing market conditions.

Thinking about business asset allocation? Keep learning: How to attract investors and invest wisely as a SMB.