The Complete Guide to Asset Allocation
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Asset Allocation is a critical topic in investing. Your asset allocation will define the mix of asset classes in your investment portfolio. For most people, this is simply the question of how much stocks, bonds, and cash they need in their portfolio.
Your asset allocation will determine your expected returns and your expected volatility. If you are willing to take on many risks (volatility), you can expect higher returns. These returns will protect you against inflation and grow your portfolio over time.
But it is important to choose an asset allocation that suits you. If you take on too many risks and panic sell at the first downturn, you would have been much better with an asset allocation with lower volatility.
In this article, we look in detail at asset allocation and a few things you can consider when choosing your asset allocation.
Asset Allocation
Your asset allocation is how much of your portfolio you allocate to different asset classes. There are many asset classes, but for this article, we focus on the main three assets classes:
- Stocks
- Bonds
- Cash
For instance, one could have an asset allocation of 5% cash, 20% bonds, and 75% stocks. Or one could have an asset allocation of 100% stocks. These are valid asset allocation examples.
Generally speaking, different asset allocations have different amounts of risks (volatility).
Now, choosing your asset allocation is critical because it must match your current situation. If you can withstand larger volatility, you can handle a larger stock allocation. But not everybody is the same, and even for one person, the situation may change over the years.
Asset Classes
It is important to realize the differences between the three main asset classes when discussing asset allocation.
Cash
By cash, I do not mean hard cash that you have a home or in your wallet. I mean cash that you have in a bank account. It could also be in a money-market fund, but this will make it less accessible. Of course, if you have a substantial amount of cash at home, you should also count it.
Cash is the safest of the asset classes. If you leave some cash untouched for 20 years in an account, you will still have the same amount (unless you have fees for your bank account!).
So, cash is the best solution when you need to spend some money because it is ready at hand and is not volatile.
The cash issue is that its returns are almost non-existent. So, it will not keep up with inflation. So, if you keep your cash untouched for 20 years, it will keep the same value, but its purchasing power will be much lower. Inflation is why people should invest and not keep everything in cash.
The reason to add some cash to a portfolio is to increase the accessibility of the money.
Bonds
Bonds are loans by governments or companies. You loan them some money, and in return, they give you back some interest during the loan duration. In the end, they will return your money.
Bonds have significantly greater returns than cash. And they are significantly less volatile than stocks. So, they are the middle ground of investing.
Keep in mind that not all bonds are equal. Some bonds have a higher yield (junk bonds) and much higher volatility. As such, they have no advantages compared to stocks. So, only safe bonds like treasury bonds should be used to reduce the risks of your portfolio.
The problem with bonds is that their returns are not high enough to sustain a lifestyle if you plan to withdraw from your portfolio. If you plan to retire only on bonds, you will need to accumulate a substantial amount of money compared to having stocks.
So, adding bonds to a portfolio is to reduce the volatility.
Stocks
Finally, stocks are shares of publicly traded companies. You buy a part of the company, and this share can grow in value over time. And in some cases, you can also receive some dividends.
Stocks can generate significantly higher returns than bonds. But they bring in significantly higher volatility as well.
The reason to add stocks is to increase returns. You want your money to grow over time.
A note about Negative-Yielding Bonds
Many people ask what they should do with their bond allocation when bonds are negative-yielding. It means that people buying bonds are losing money over time.
In Europe and Switzerland, bonds have had a negative interest rate for several years, up to 2022. In the U.S., bonds still yield a positive interest rate, which is very low.
So, what if you do not want to go 100% in stocks but do not want to invest in negative-yielding bonds?
When cash has higher returns than negative-yielding bonds, it makes sense to increase your cash allocation instead of your bond allocation.
Now, cash will have low returns, below inflation. So, if you do not have access to good bonds, you may want to have a higher allocation to stocks and a lower allocation to cash than if you had access to good bonds.
In 2023, the Swiss bonds have once again a positive interest rate.
Risk Capacity
How many stocks and bonds you will choose for your asset allocation will depend on your capacity to take risks.
Your risk capacity will depend on several factors. The first factor is personal. Some people are willing to take more risks than other people. Some people would never have 100% in stocks because they would not be able to weather it.
If you sell everything when your portfolio is down 10%, your risk capacity is quite low. On the other hand, if you do not panic when your portfolio is down more than 50%, you have a great risk capacity. Now, it is pretty much impossible to know your risk capacity without experiencing it. Many people think that they would not panic, but in practice, it is sometimes different.
Another way to approach your risk capacity is based on your current financial situation. If you are currently still working (at a stable job) and are heavily investing to accumulate a large net worth, the chances are that you can take on a lot of risks.
On the other hand, if you are already retired without income and live from your investments, it may be more dangerous to take on many risks. Indeed, if you have to sell during a large downturn, you may make your situation more difficult. This risk is called a sequence of returns risk.
Finally, your asset allocation will also depend on your goals. If you are willing to retire early with your portfolio, you will need a large allocation to stocks if you want your portfolio to last a long time. If you plan to retire at 60, you probably do not have to plan for more than 40 years of retirement.
But if you plan to retire at 40 (or even earlier), you are looking at a very long retirement. And to sustain a very long retirement, you need an asset allocation with a substantial allocation to stocks.
So, there are many things to consider when you decide on your asset allocation.
Rules of thumb
Over the years, there have been a few rules of thumb to choose your asset allocation easily.
The most well-known rule is to hold your age in bonds and the rest (100 minus your age) in stocks. For instance, if you are 40 years old, you will hold 60% in stocks and 40% in bonds. The problem with this rule of thumb is that it is too conservative for most people. For me, at 32 years old, in the accumulation phase, 32% of bonds do not make sense. Also, life expectancy has changed since the introduction of this rule. So, the rule needs to be revisited.
A more recent rule of thumb is to hold 120 minus your age in stocks. If you are 40 years old, you will hold 20% in bonds and 80% in stocks. And at 60, you will be at 40% bonds and 60% stocks. For me, it would give 88% in stocks currently. It already makes more sense. But this is still a rule of thumb.
Even though rules of thumb can help you understand what people do, your asset allocation depends on too many parameters to rely on a single rule of thumb. As we saw in the previous sections, you need to take into account your risk capacity, your current situation, and your goals.
The bigger picture
There is one thing many people forget when they consider their asset allocation is to consider the big picture.
When considering your asset allocation, you should not only consider your broker account assets. You should also think about your retirement assets. The bigger picture is fundamental to consider.
For instance, if you have a large second pillar, you probably do not need bonds in your third pillar or investment portfolio. And on the contrary, if you have 10% of bonds in your investment portfolio but all the rest is in stocks, you may not have the asset allocation.
Your asset allocation should always apply to your entire net worth, not to a portion of it.
Your asset allocation is not fixed
I mentioned before that your current situation is important when considering your asset allocation.
Since your current situation will change over time, so may your asset allocation. In total, there are four stages of wealth. For instance, I mentioned before that your asset allocation during the accumulation phase might not be the same as during the asset preservation phase.
Or, if you lose your job (or quit your job for some time), you may want to have a few more bonds to help you cope in a downturn.
So, when your situation changes, you may want to review your asset allocation accordingly. In general, you should probably review it once a year.
Diversify
Some people mix up asset allocation and diversification into each asset class. I prefer to keep these two concepts separated.
Once you have chosen your asset allocation, diversification is crucial. Within each of your asset classes (except cash), you should diversify. This will greatly reduce the volatility in your portfolio.
So, if you have 60% of stocks, you still need to diversify these stocks. For these, index funds are great because they let you invest in thousands of stocks with a single fund. And index funds also let you diversify globally by investing in each country.
And you should also diversify your bonds with many bonds. But you probably should not diversify your bonds globally if you do not want to lose the volatility reduction advantage of bonds.
Conclusion
With this guide, you should be able to start setting your asset allocation. To do it well is more important than people think. And it is also more difficult to set than some people may make it look like.
Most rules of thumb are outdated and too simplistic to set your asset allocation. Your asset allocation is too much of a personal thing for a simple rule of thumb to help.
Hopefully, you will now be able to set your asset allocation. Now, the next step is to choose your investment portfolio and start investing.
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Hi Baptiste,
Thank you for the useful article.
In the case of investing a large sum (f.e. 100k), what approach would you recommend? Investing it all at once or spreading the investment over a longer period?
Thanks in advance
Hi Vanessa,
I have an article about how to invest lump sums.
Dear Baptiste,
I really love your blog and your FIRE calculator, thanks for the excellent work!
I’m in desperate need for some advice: Reading about what bonds to hold in a FIRE-portfolio, I get confused about all the options. What would you hold in your portfolio for the bond part?
– 10 year US treasuries (CHF-hedged for Swiss guys), like used for the Trinity study and your FIRE calculator?
– a total world bond fund, such as BNDW (including treasuries and corporate bonds of various durations?)
– a bond ladder of individual treasuries?
– is it better to hold Swiss bonds, or US, or global, for a Swiss guy?
– Do you think corporate bonds are a good idea, or too risky compared to treasuries?
What’s the pros and cons, and what’s a good FIRE bond allocation for FIREing with age 40?
Your support is greatly appreciated!
Maybe I need to add: I’m looking for the ideal bond allocation for my FIRE portfolio (to withdraw from regularly). In my current accumulation portfolio, I hold 100% stocks.
Your FIRE simulation gives me the best results for 30-40% of bonds in my FIRE portfolio in terms of success rate and worst durations.
Hi Roberto,
I am definitely not a bond expert. But as a Swiss investor, I would only use Swiss bonds. Currency risk or hedging does not make sense in the long term for bonds.
I would use CH treasury bonds, in an ETF. Or maybe mix with some bonds directly from a bank.
Only you can choose your bond allocation, there is no one-size-fits-all rule.
Thanks a lot for your response, very much appreciated! To replicate the Trinity results as closely as possible which used 10-year US-treasuries, I assume 10-year Swiss treasuries would be best?
I fear that if I deviate too much from the assets used in the Trinity study, my outcomes would look very differently.
That would be best. But keep in mind that historically Swiss bonds have performed worse than US Bonds.
I have done some simulations with CH stocks, but I do not have good data on CH bonds.
Hi Baptiste,
Thanks for so much information, I’m learning a lot from you.
I am 40 years old and I am going to start investing thanks to you. I would like you to give me your opinion about the assignment I have made for myself (I have almost no money invested in the 2nd Pillier):
40% International stocks
20% Swiss stocks
20% gold ETF
20% cash (to replace the bonds, since they are giving a negative interest rate, and so I have money for an emergency)
Thanks for any advice or comment.
All the best,
Itziar
Hi Itziar,
Keep in mind that only you can choose the best asset allocation since only you have all the information.
Given the data I have (40 years, starting = medium to low risk tolerance), it seems your asset allocation makes sense. It is conservative, yet diversified. Just don’t expect very higher returns given you have 40% outside of stocks. But these 40% should give you extra stability.
Always a joy to read your posts :)
How do you treat real estate? For example do you include the place you live in your asset allocation if you own it?
I know that some believe you shouldn‘t include your house/condo in your AA.
For me personally I decided to include it since I think it is an asset in the sense that it is a store of value even though it is not as liquid as bonds/stocks. Even if you don‘t own real estate you could argue that you should include real estate in your AA (as a liability with your rent as interest) since you always need a place to live whether you own it or not. In the case of renting you‘re shorting real estate assets so to speak.
What are your thoughts?
Hi Mark,
I think both ways are working fine. However, it is important to realize that the house you live in is not an investment and not liquid at all. You own it, but you can’t use it for FI for instance.
In my net worth, I account for my house, minus the mortgage. But I do not consider it a real investment, so it does not count towards my Financial Independence goal.
In my current asset allocation (the effective one), I have real estate, since it’s an asset I own.
But my target asset allocation (the one this article focuses on), I do not have real estate since I do not plan to invest in it.
Does that make sense?
I think it is a personal decision to include or exclude the place you live in your AA. However I don‘t agree that it is not a investment. Consider Alice and Bob. Each of them have 2 Million in cash and both need 80‘000/year to live which is possible under the 4% „rule“. Both pay rent of 20‘000/year for their apartments (they both live in the same building). One day they both are offered to buy the apartment for 500‘000. Alice takes the offer and Bob decides to continue to rent. With the investment of 500K Alice saves the rent of 20K and therefore still earns 4% by avoiding rent. It seems to me that both are equally well of. Alice has 60K per year generated by 1.5 Mio of (liquid) Assets while Bob has 80k yearly generated by 2 Mio from which he needs to deduct 20K per year.
The only difference between their investments are the asset classes they put their money into.
We can take this one step further: Bob could decide that he buys another flat (also 500K) in the same building and renting it out to Carl for 20K/year while he decides to stay in his apartment as a renter. Now Bob has exactly the same Assets as Alice. Is it now an investment?
Hi Mark,
Considering it an investment or not is also a personal decision.
For me, an investment should yield me some money that I will be able to use. Since I live in the house, I will never be able to rent it out and never be able to sell it out (otherwise I would be buying another one or renting another one).
Yes, in many cases, you can save money by buying a property to live in. But in many cases, people do not consider the big picture. In your case, you are not considering the fact that Alice now has to pay many things that Bob does not have to pay, for instance water and renovations. And having a house without a mortgage will likely increase Alice’s taxes higher than Bob’s.
I am not saying that buying a house is a bad money move. I am just saying that for us, it’s not an investment.
I’ve been following your blog for over a year now, and have really made great leaps in learning about investing. In fact, I realized that, at 36, with a solid second pillar that already makes 36% of my entire worth, I should probably invest all the remainder of my funds in stock. I’ve progressively been doing so but apparently not aggressively enough… so I’m still holding abt 25% of my worth in cash. Basically, if I want to finally reach my ideal allocation, which would be at about 80ish% stocks, I would have to invest a substantial sum in stocks which I’m somewhat reluctant to do in this volatile environment. But dividing it up into smaller monthly deposits will take way too long, I feel, and meanwhile, all the cash in my account is losing value due to inflation. What do you recommend? Going for a large sum and continue w small installments or larger installments over a long period of time?
Hi Will,
Congratulations on having made improvements to your financial life!
With 36% in your second pillar, it may make sense to invest aggressively indeed, although this may depend on your goals too.
I have an article about Dollar Cost Averaging vs Lump Sum. On average, it’s always better to invest now than to delay investing. When I get my bonus, I always invest it directly, I don’t try to spread it. Of course, it’s more scary, but on average, it pays out.
Great article and thanks for that.
Do you have a strategic asset alloation (long-term, strategic) and a tactical asset allocation (short-term, tactical movements)?
Thanks in advance.
Have a good one
Hi Ueli,
No, I do not :) I only have a long-term asset allocation.
So far I am not considering any tactical short-term investing, I am probably not smart enough for this :)
Thanks for stopping by!
This is great!
“Your asset allocation is too much of a personal thing for a simple rule of thumb to help.”
A lot of rules of thumb are quite outdated like you mentioned of the 100% rule.
Asset allocation is quite important just stick to your strategy.
Hi Steve,
Excellent point! People need to be careful about absolute rules in investing!
And many people should stop sharing these outdated rules.
Thanks for stopping by!