Asset allocation is how you divide investments among stocks, bonds, cash, and alternatives — it is the single biggest driver of long-term portfolio outcomes.
The right mix depends on your goals, timeline, and tolerance for market swings, not on chasing whatever performed best last year.
Diversification smooths returns over time, but overlap in popular index funds can silently concentrate your portfolio in a handful of mega-cap names.
Once the allocation is set, ongoing rebalancing is essential to keep the portfolio aligned with your plan.
A Personal Perspective
Many years ago, prior to becoming an advisor, I was excited when I turned 21, as I became eligible for my employer's 401(k). I started looking at the available investment options with fancy names and then the performance of those funds. I picked an S&P 500 index fund because I heard that was appropriate, and then I added an active mid-cap fund that had great historical performance.
Not bad, but had I known about asset allocation, I would have had a much broader mix of funds as well, not tinkered with it throughout the years (chasing performance).
What is Asset Allocation?
Simply the way you divide your investments among the different asset classes. Asset classes have subclasses and segments further to define the different options within an asset class. Below is a broad example of asset classes and subclasses.
Why Does Asset Allocation Matter?
The easiest way to think of this is if your portfolio is a pie, what will be the percentage of the different asset and sub-asset classes/segments across the pie? Tilting too much in a particular direction can create too much risk or not enough risk in your portfolio.
A Real-World Example
Consider the period from December 31, 2001 to December 30, 2011 (post dot-com bubble). With a 50/50 allocation between the S&P 500 (Large Cap) and S&P 400 (Mid Cap), without including an international position, an investor would have left significant gains on the table.
The goal of asset allocation is not to get the market timing right but to be diversified so that when markets do change, your portfolio is already positioned to benefit from the rotation in the long run.
How to Determine the Asset Allocation?
Key questions to consider:
Modern Portfolio Theory (MPT)
The guiding principle behind building allocations is to maximize the expected return for the given level of risk a client is willing to take.
Each client’s situation determines the asset allocation at the portfolio level (all accounts) but also at the individual account level if it is being used for a specific goal.
The Power of Diversification
There are just over 4,000 public U.S. companies listed on a stock exchange. Even the largest investment firms cannot research all these companies, and the odds of picking individual winners are very difficult.
A 2018 study revealed: From 1926–2016, only 4% of all U.S. stocks generated most of the overall market gains while most stocks performed poorly or matched the returns of treasury bills.
The Overlap Problem
The opposite challenge we see when evaluating new clients’ existing portfolios is overlap. Meaning you have funds with different objectives, but because of the dominance of mega-cap tech companies, you have overlap.
For example, let’s say you own the 3-fund allocation below:
The Issue: Although all three track a different index, they all contain the same top holdings, effectively concentrating your portfolio in those names.
In Summary
Proper asset allocation is critical to building a portfolio that meets a client’s goals while ensuring it is diversified to capture the returns of the different asset classes and segments over time.
Once the asset allocation is agreed upon, ongoing rebalancing is essential to maintaining the target weightings of the portfolio.
Without a process in place for the setup and then the monitoring/rebalancing, you are putting yourself at risk of chasing returns instead of letting the asset allocation do its job.
