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asset allocation

Also called: allocation, stock/bond mix

How a portfolio is split between stocks, bonds and cash; the choice that shapes most of its risk and return.

Asset allocation is how a portfolio is split between stocks, bonds and cash, for example 60% stocks and 40% bonds, written 60/40. It is the choice that shapes most of a portfolio's risk and long-run return, more than which particular funds you pick.

More stocks usually means a higher expected return and deeper, longer falls. More bonds means a smoother ride and less growth. The right mix depends on two things: risk capacity, meaning how long until you need the money and how stable your income is, and risk tolerance, meaning how big a fall you can sit through without selling.

Popular rules of thumb, such as holding your age in bonds, are trade-offs rather than rules. Bonds are not riskless either: in a high-inflation year they can fall together with stocks. A good allocation is one you can keep through a bad year.

Example

Zapas tests mixes on its synthetic 40-year history, in real terms. All bonds (0/100) grows 1.7% a year, turning $1,000 into $1,932; its worst year is −12.7%. A 60/40 mix grows 4.4% a year to $5,700, with a worst year of −20.0% and a maximum fall of −30.0%. All stocks (100/0) grows 5.9% a year to $9,875, but its worst year is −31.8%, its maximum fall −48.2%, and it spends 11 years below its old peak.

The worst year for every mix with 60% or less in stocks is year 36, when stocks and bonds fell together. The history is invented for the course.

Common mistakes

  • Choosing more stocks than you can hold through a fall of almost half.
  • Assuming bonds never lose money.
  • Treating a rule of thumb like "your age in bonds" as a law.
  • Investments can fall, and you can get back less than you put in.

Learn it in the course