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Asset Allocation

Quick Answer

Asset allocation is the process of dividing an investment portfolio among different asset classes, such as stocks, bonds and cash. The aim is to choose a mix of assets that reflects an investor’s objectives, investment horizon and willingness or ability to accept risk, rather than relying on a single type of investment.

How does Asset Allocation work?

Asset allocation determines how much of a portfolio is assigned to different categories of investments.

For example, a portfolio might allocate:

  • 50% to stocks;

  • 30% to bonds;

  • 20% to cash or cash equivalents.

The allocation is usually expressed as a percentage of the total portfolio. FINRA explains that asset allocation refers to the proportion of a portfolio invested in different asset classes, such as stocks, bonds and cash.

Different asset classes can respond differently to economic conditions, interest rates, market sentiment and other factors. Combining assets with different risk and return characteristics may therefore change the overall behaviour of a portfolio. CFA Institute notes that portfolio risk depends not only on the risk of individual assets but also on the correlations between their returns.

Over time, market movements can cause an allocation to move away from its original target. Rebalancing means adjusting portfolio holdings to bring them closer to the intended allocation. Investor.gov notes that this may be done periodically or when an asset class moves beyond a predefined range.

Key features of Asset Allocation

Several characteristics are important when understanding asset allocation:

  • It divides a portfolio among asset classes: Common examples include stocks, bonds and cash.

  • Allocations are usually percentage-based: Each asset class represents a specified share of the total portfolio.

  • Risk tolerance matters: Investors with different abilities or willingness to accept losses may choose different allocations.

  • Time horizon matters: The period for which funds are expected to remain invested can influence the appropriate mix of assets.

  • Diversification is related but separate: Asset allocation spreads investments across asset classes, while diversification can also involve spreading investments within each class.

  • Allocations can change: Rebalancing can restore a portfolio to its target mix after market movements alter the percentages.

Simple Asset Allocation example

Suppose an investor has a portfolio worth $100,000 and chooses the following hypothetical allocation:

Stocks: 60%
Bonds: 30%
Cash: 10%

The portfolio would initially contain:

$100,000 × 60% = $60,000 in stocks
$100,000 × 30% = $30,000 in bonds
$100,000 × 10% = $10,000 in cash

Assume the stock portion later rises to $70,000, while bonds and cash remain unchanged.

The portfolio is now worth:

$70,000 + $30,000 + $10,000 = $110,000

Stocks now represent approximately:

$70,000 ÷ $110,000 × 100 = 63.6%

The allocation has therefore moved away from the original 60% target. Rebalancing could involve adjusting the holdings toward the original percentages.

This example is illustrative only and does not represent an investment recommendation, FxGrow portfolio service or expected return.

Potential benefits and uses

Asset allocation may help investors structure portfolios according to their intended balance between risk and potential return.

It can be used to:

  • distribute investments across different asset classes;

  • reduce dependence on the performance of one category;

  • align a portfolio with a particular investment horizon;

  • manage the overall level and type of portfolio risk;

  • establish target percentages for portfolio monitoring and rebalancing.

CFA Institute explains that combining assets whose returns are less than perfectly correlated can reduce overall portfolio risk.

However, asset allocation should not be interpreted as eliminating risk.

Risks, limitations and common misconceptions

A common misconception is that asset allocation and diversification are exactly the same thing. They are related, but distinct.

Asset allocation determines how much of a portfolio is placed in different asset classes. Diversification goes further by spreading investments both between and within those asset classes. FINRA notes that simply having an asset allocation does not necessarily mean a portfolio is sufficiently diversified.

Another misconception is that diversification guarantees protection against losses. It does not. Different investments can decline at the same time, particularly during periods of broad market stress.

Asset allocation also cannot determine a universally correct portfolio. Investor.gov emphasises that appropriate allocations vary according to factors including time horizon and risk tolerance.

Historical correlations between asset classes can also change. Assets that previously moved differently may become more closely correlated during particular market conditions.

Finally, rebalancing may involve transaction costs, taxes or other consequences depending on the investment structure and jurisdiction.

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