When you start doing research about investing, you’ll probably learn pretty quickly that every choice you make with your money has a risk and a reward.
Certain ways to hold your money, like savings accounts, offer near-complete security and federal insurance. They come with almost no risk (besides the value you might lose to inflation) but also provide low returns. Other investments like stocks are riskier, meaning you might lose money you put into them. But you take this risk with the hope that your investment will pay off—and you’ll end up with substantially more than you put in over time.
To try and decrease the amount of risk you have to take on to see potential reward, many people diversify their investments. That is to say, they put their eggs in many baskets.
You probably know that at its simplest diversification means you should invest in a mix of stocks and bonds. But how do you determine which kinds of stocks and bonds to invest in—and what percentage you should put in each? That’s where asset allocation comes in handy.
What’s the definition of asset allocation?
Asset allocation is the distribution of assets you have. Remember: “Asset” is basically just another way of saying stocks, bonds, mutual funds, exchange-traded funds (ETFs), art, land or anything else you might invest your money in.
If you only own stocks, your asset allocation would be 100 percent in stocks. And likewise, if you only owned bonds, it would be 100 percent in bonds. But most of us probably want asset allocations that aren’t quite that binary.
Holding only stocks means you’ll feel the extreme ups and downs of the stock market, and in the short term, you might lose a lot of value on paper. (But remember: you don’t actually lose anything unless you sell stocks when the market is down and lock in your losses.) And only having bonds means your balance may be steady, but your returns may be a fraction of what you might get from stocks.
That’s why most experts suggest you balance your asset allocation to manage your risk while still positioning your money to grow over time. There are a few ways you can think of your asset allocation: by risk, by time and by age.
How to think about asset allocation
Asset allocation by risk
Some of us are born risk takers when it comes to our money. We’re willing to accept great potential for loss for the chance our money might grow. Others of us get stressed at the thought of losing even a dollar of our savings.
That willingness to potentially lose money to make money is called “risk tolerance.” Some investments are conservative, meaning they probably won’t lose value in the short term and are low risk. These might be bonds or funds that contain bonds issued by reputable, highly rated companies and governments. They’re considered low risk because the companies and governments whose debt you’ve bought have a good track record of paying people back.
Other investments are aggressive, meaning they might lose or gain substantial value and are therefore higher risk. Investing in an individual stock, for example, can be risky, as you’re betting on one particular company. Stock funds, like index funds, are still considered aggressive but are generally thought to be less risky because they give you exposure to many stocks. Instead of being dependent on one company’s performance, you benefit from the performance of hundreds or thousands of companies. While individual companies have gone bankrupt, it’s not common, and the overall stock market never has gone to zero.
When thinking about your asset allocation, ask yourself how much money you’re hypothetically willing to lose.
If the thought of losing any value—even if it’s only temporarily—would keep you up at night, you might want a more conservative asset allocation with more bonds and bond funds. You may have to contribute more of your own money to reach your goals, as stocks have had higher returns historically, but you’ll also have to weather less volatility.
If, on the other hand, you’re willing to take on short-term losses for long-term gains, you may want a more aggressive allocation with more stocks and stock mutual funds or ETFs.
Asset allocation by time
When considering the breakdown of your asset types, you should also think about how long you’re investing for. For short-term goals, like saving for a vacation or a wedding, you might want a more conservative asset mix that could include cash (in a high-yield savings account), Certificates of Deposit or short-term treasury bills. Because you’re going to need the money relatively soon, you don’t want to risk it not being there when you need it.
But for goals that are at least a few years away or those with flexible timelines, you may be willing to take on more risk so you can grow your money more in the market. That’s where diversified mutual funds and ETFs may come in.
Even though the value of your stocks and stock funds may decrease from time to time, historically, the market has recovered from each downturn it's endured. It’s more a matter of when than if, which is why experts recommend you only invest money in stocks and stock funds that you aren’t going to need immediately or in an emergency.
For reference, the average bear market, defined as a dip of at least 20 percent from a recent high, lasts about 10 months. But it can take about three years for the market to return to its previous highs, on average.
That lag is the primary reason you may not want a lot of money invested in stocks or stock funds if you’re going to need it in the near future. For further off or more flexible goals, though, that delay lets you scoop up shares at heavily discounted prices. Then when the market recovers, you stand to make even greater gains.
Asset allocation by age
Determining your asset allocation by your age is primarily for planning for the ultimate long-term goal: retirement.
Most financial advisors recommend you use the Rule of 100 to determine your breakdown. According to the Rule of 100, you subtract your age from 100 and the resulting number is the percentage of your portfolio that should be stocks.
Someone who is 33, then, should have 67 percent stocks or stock funds and 33 percent bonds or bond funds.
Because the percentage of bonds or bond funds you own increases as you age, the Rule of 100 automatically becomes more conservative as you get older and have less time to recover from downturns before you need your money.
That said, with rising American life expectancies, some now advocate for a Rule of 110 or 120 to give your money more time to grow via stocks to fund longer retirements.
To stick to the Rule of 100 (or 110 or 120), you must rebalance your portfolio holdings every year. Assuming no changes in value took place, you’d need to sell 1 percent of your stocks to buy 1 percent more bonds.
But the stock market is rarely as consistent as that. If your stock holdings have grown dramatically in value in a given year, you’d need to calculate what percentage they now account for in your portfolio and then sell off enough to bring your portfolio in alignment with your age. While this rebalancing isn’t hard, it can get pricey if you’re paying trading fees each time you make changes to your portfolio.
If updating your investment portfolio every birthday doesn’t sound appealing to you, many robo advisors, including Acorns, can rebalance your portfolio for you. Acorns offers risk- and age-adjusted diversified portfolios that provide exposure to thousands of stocks and bonds and regularly rebalances your portfolio. Acorns Later Individual Retirement Accounts (IRAs) update holdings over time so you stay in an age-appropriate retirement portfolio.
Investing involves risk including loss of principal. This article contains the current opinions of the author, but not necessarily those of Acorns. Such opinions are subject to change without notice. This article has been distributed for educational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.