Asset Allocation – How to Diversify Your Investment Portfolio to Maximize Return and Minimize Risk

Asset allocation is essentially related to grandma’s old cliché: don’t put all your eggs in one basket. In financial terms, you don’t want to have the majority of your investment portfolio tied up in the same investment. If something should go wrong, you’d likely lose everything.

Instead, you need to know how to allocate your assets in various ways. This provides backup protection if something goes awry.

That brings us to asset allocation, one of today’s most common investment portfolio management strategies. Asset allocation can help you create a portfolio of investments using different asset classes. This helps you maximize your growth potential while limiting market risks.

What is Asset Allocation?

Asset allocation divides your assets into different investment classes, such as stocks, bonds, real estate, cash, commodities, precious metals, foreign currencies or other investments. However, you don’t need all these asset classes to maintain a well-diversified investment portfolio.

You can further diversify your asset classes by breaking these into subcategories. For example, if you invest in the stock market through mutual funds, you can choose funds by size (small, mid-cap, or large-cap) and style (growth, value, international, etc.).

The goal is to diversify your assets across different investment classes to provide growth, outpace inflation, and protect against any single investment losing value. We’ll dive deeper into explaining asset classes in a moment.

Factors to Guide Your Asset Allocation – Risk Tolerance and Time Frame

If you plan to build your portfolio according to the principles of asset allocation, there are two more items to consider:

1. Risk Tolerance

Risk tolerance includes both your financial and your emotional capacity to handle market swings. If you have a higher tolerance for risk, you can handle more stocks in your portfolio.

However, if you have a lower risk tolerance, you may wish to have more bonds and cash in your portfolio.

2. Investment Time Frame

The second major consideration is your time frame. When you have a longer time frame, taking more risks with your asset allocation might make sense since you can make up for losses. However, a shorter time frame might mean it’s time to shift assets toward investments such as cash or bonds, which are considered less risky.

How Asset Allocation Protects You

Asset allocation adds diversity to your portfolio. The idea is to build your portfolio so that the included asset classes move differently in response to market conditions.

For example, stocks and bonds often move in different directions (though not always). So if you have a portfolio that includes bonds and stocks, you can take advantage of both situations. Additionally, adding other asset classes can help you limit your losses when one of the asset classes in your portfolio is struggling.

It’s important to carefully consider your situation and goals, though. Many studies have shown that asset allocation is more closely tied to long-term success and the ability to meet your goals than to picking the right investments. An appropriately diversified portfolio is more likely to do well for the average investor than stock picking.

Which Asset Classes Do You Need in a Balanced Portfolio?

The SEC beginner’s guide to asset allocation lists three asset classes: Stocks, Bonds, and Cash (and cash equivalents). You can certainly build a balanced and diversified investment portfolio with just these three asset classes. This becomes more evident when you include diversified mutual funds or index funds, which hold equities across hundreds or even thousands of companies.

Let’s take a look at the various asset classes and how they can impact your investment portfolio:

Stocks

Owning stock in a company is the same as owning part of the company. Over time, the stock markets have far outpaced inflation and delivered among the best returns on investment. However, stocks tend to be volatile, with wide swings in valuation from month to month and year to year.

Because stocks are more volatile, it makes sense to avoid purchasing individual stocks and instead focus your investments on index funds, mutual funds, or Exchange-Traded Funds (ETFs). Index funds, mutual funds, and ETFs are already diversified, as each fund contains shares of dozens or even hundreds of different companies.

So instead of trying to pick the best stock, you can buy a fund that tracks the entire stock market or a segment of the market, such as a sector-based fund (sector funds track segments like technology, health care, energy, etc.).

Bonds

A bond is essentially owning an IOU from a government or a company. Organizations issue bonds to raise cash to fund operating expenses. In return, they promise bondholders a guaranteed return on their cash.

Bonds are considered to be less risky than stocks. However, that does not mean they are without risk. The least risky bonds are U.S. government bonds, which are often considered among the least risky investments. Other types of bonds include Municipal Bonds (those issued by local governments), corporate bonds (issued by companies), and junk bonds (usually higher-risk bonds issued by companies with lower credit ratings).

All of these can be profitable but can also have risks. Associated risks include non-payment or failure to keep up with inflation.

Investing in individual bonds can be tricky and time-consuming for the lay investor. It is recommended that most people invest in a bond fund that holds multiple bonds (essentially an index or mutual fund for bonds). Read the prospectus to ensure you understand what the fund includes.

Cash & Cash Equivalents

Cash is the third building block of most portfolios. Don’t be put off by the term “cash equivalents.” It more or less just means “cash.” Cash and cash equivalents include money held in your savings accounts, Certificates of Deposit (CDs), money market funds, and treasury bills.

These are generally considered the “safest” investments, meaning they won’t lose face value. But there is a risk with keeping too much cash in your portfolio, as cash and cash equivalents generally don’t keep pace with inflation over the long term.

Other Types of Investments – Use These Sparingly

Most investment portfolios comprise the three major asset classes mentioned above – stocks, bonds, and cash. However, there is still an opportunity to add other types of investments to your portfolio.

That said, most of the following types of investments should generally comprise a smaller percentage of your overall investment portfolio unless you are an expert in these asset classes.

For most of us, however, a little is all that is needed.

Real Estate Investing

Real Estate is one of the oldest ways to invest. It can be a great addition to your investment portfolio, but it isn’t for everyone. Rental properties often require a lot of hands-on commitment and knowledge. This is best avoided unless you have the time and ability to be a real estate investor and landlord.

You can invest in real estate in other ways, such as crowdfunding platforms, Real Estate Investment Trusts (REITs), or a real estate investment syndication, in which you pool your money with other investors and a third party manages the investment. All of these can be good ways to diversify your investment portfolio without taking on the same risk as adding physical property.

Precious Metals Such as Gold and Silver

I’m not a fan of investing in gold, silver, and other precious metals. If you buy physical gold or silver, you need a safe place to store it (or pay someone to store it for you). You should also insure it, which has an added cost.

Physical gold is also taxed as a collectible, up to 28%. This is unlike other investments, which are generally taxed at either long-term capital gains rates or your marginal tax bracket.

Finally, precious metals don’t generate income such as dividends. At most, they may work as a hedge against inflation. Precious metals shouldn’t make up a large percentage of most investment portfolios.

Investments to Avoid in Your Investment Portfolio

The following “investments” are highly volatile and are usually more speculation than investment. They should be avoided in long-term investment portfolios.

Foreign Currencies

Foreign currencies are often among the more volatile investments and should be avoided by most lay investors. I recommend keeping foreign currencies in your portfolio only if you reside in more than one location and have a genuine need for different currencies. Otherwise, you will be better off investing in the prime asset classes of stocks, bonds, and cash.

Commodities

Most investors never need to consider commodity prices, much less invest in them. Like gold and precious metals, commodities don’t pay out dividends or otherwise offer value to investors. They can also be highly volatile. Stick to stocks, bonds, cash, and maybe a little real estate.

Cryptocurrencies

Simply put, people don’t invest in cryptocurrencies. They speculate on them. While it’s true that many people have made a lot of money with cryptocurrencies, the reverse is just as true. Cryptocurrencies are still very new and highly speculative. If you decide to own any crypto, make sure you do it with an exit plan and only with a small portion of your overall investment portfolio. Call it mad money, if you will.

How to Find the Right Asset Allocation Plan for You

Finding the right balance among your investments is key. You want the right mix of stocks and bonds to maximize your returns. For some, finding a balance only comes after consultation with a financial professional. Professionals can help you through a risk assessment analysis to pinpoint where your investments should go. Understanding what you already have in your portfolio will help you determine which other investments you should use for retirement.

Various software packages help you devise an allocation plan suited to your financial situation and goals. While the software can help with their decision-making process, they cannot make judgment calls based on intuition. You will not rely on a single resource to build an asset allocation plan. You will need to consider several factors, including an individual’s age, risk profile, and retirement goals.

Define Your Investment Timeline

Your nest eggs are all for the same purpose – retirement years. You want to aim high so you’ll be able to retire when you want and live how you want after retirement. The essence of saving for your Golden Years is to start as soon as possible. The younger you are when you start saving, the more you will accumulate.

Besides the age you start, another important factor in your retirement investments is the risk you take with your investments. Younger individuals can afford to take more risks than those planning to retire in the next few years.

Risky or Conservative?

Depending on your situation, you’ll want to select from a diversified group of stocks, bonds, and cash investments. For investors who are still young and have years until retirement, investment portfolios may be weighted more toward higher-risk stocks. Still, the returns are larger for those with less time until retirement or who prefer to remain conservative, with a portfolio filled with bonds and cash.

Stocks Versus Bonds

Investing in stocks will help your investment portfolio outpace inflation and give you more spending power. But stocks are more volatile than some other investments and are generally considered better for long-term growth than for short-term financial needs.

Because of this, many investors choose to keep a portion of their investment portfolio in bonds. While returns are usually smaller in the long run, bond investing tends to be much steadier than stock investing, resulting in lower volatility.

With so many factors affecting your choice in where and how to allocate assets, you should consult with a professional investment consultant to gauge where you are and where you want to be when retirement looms on the horizon.

Percentage of Other Investment Types

You aren’t limited to stocks and bonds in your investment portfolio. Other commonly held investments include gold, silver, and other precious metals; real estate or Real Estate Investment Trusts (REITs); cash; commodities; foreign currencies; cryptocurrencies; and other investments.

As mentioned above, there are pros and cons to adding these types of investments to your investment portfolio. Limiting your exposure to other types of investments is generally a good idea, as overweighting your portfolio with them can significantly increase your risk.

If you decide to invest in these, it’s best to usually limit it to 5% – 10% of your entire investment portfolio. For example, I currently hold close to 10% of my investment portfolio in REITs. I do not currently invest in any precious metals, commodities, foreign currencies, or cryptocurrencies.

Sample Asset Allocation Plans

Most people refer to their asset allocation as a split between stocks and bonds, which are generally among the largest components of their investment portfolios. This is usually written with the percentage of stocks, followed by the percentage of bonds.

For example, an 80/20 investment portfolio would include 80% stocks and 20% bonds.

Common asset allocation plans are:

• 90/10 (90% stocks, 10% bonds)
• 80/20
• 70/30
• 60/40
• 50/50
• 40/60

Most people don’t go below 40%-50% in stocks, even as they enter retirement. While it’s true that including a higher percentage of bonds can reduce your overall risk, most investment portfolios still need to produce gains to outpace inflation and support retirement spending. So maintaining a decent percentage of stocks allows the portfolio to continue growing while reducing overall risk.

Keep in mind, there will always be a risk with non-guaranteed investments (basically anything other than guaranteed government bonds).

Further Breaking Down Your Asset Allocation

Most investors also further subdivide their investments. For example, if you have an 80/20 portfolio, you may further subdivide the stock and bond percentages by type.

Let’s say you have an 80/20 portfolio. You may wish to break up your stock percentages to include a fixed percentage of US-Based stocks and another percentage of International Stocks. Some people subdivide this further by including percentages of classes of U.S. stocks and different classes of International stocks.

You can do the same thing with bonds and invest in different types of bonds.

For example, your 80/20 portfolio could be broken down like this:

• 80% Stocks – 50% U.S. Stocks, 30% International Stocks.
• 20% Bonds – 10% U.S. Government Bonds, 10% Corporate Bonds

Another example of an 80/20 investment portfolio that takes this idea a step further:

• 50% U.S. Stocks (30% Large Cap, 10% Value, 10% Small Cap)
• 30% International Stocks (20% International Developed Countries, 10% Emerging Markets)
• 10% U.S. Government Bonds (5% I Bonds, 5% TIPS)
• 10% Corporate Bonds (5% low-risk corporate bonds, 5% junk bonds)

These are just samples. You can mix and match to the asset allocation that works best for your risk tolerance and investment timeline.

Rebalancing Your Investment Portfolio

An important part of asset allocation is rebalancing your investment portfolio. Over time, your investment portfolio may stray from your ideal asset allocation.

This can happen for many reasons.

For example, stocks may experience a long bull market, as we have seen since the Great Recession. Of course, during the Great Recession, the balance of most stock portfolios dramatically decreased. These changes in the valuations of your holdings will often take your asset allocation out of balance.

Rebalancing your investment portfolio is simply taking action to bring your asset allocation back in line with your preferences.

So if your preferred asset allocation is 80/20 and it drifts to 85/15, you would sell 5% of your stocks and buy enough bonds to bring your allocation back to 20% bonds. Ideally, you would do this inside a retirement account to avoid any taxable events.

Another way to rebalance your asset allocation is to direct new investments where they are needed. This avoids the need to sell anything and reduces the potential for taxable events. This may take longer to achieve, but it can reduce your expenses.

Changing Your Asset Allocation

You may also decide to change your asset allocation based on your age, life events, changes in your risk tolerance, or other factors.

The asset allocation you have right now may not be appropriate in five or ten years. A good example is investing for retirement.

When you are younger, your asset allocation might favor stocks, with perhaps 70% of your portfolio in stocks, 20% in bonds, and 10% in real estate.

As you approach retirement, though, shifting that allocation is important. You might move to a position with 60% in stocks, 25% in bonds, 10% in real estate, and 5% in cash.

As you enter retirement, your allocation might be 50% stocks, 35% bonds, 10% real estate, and 5% cash.

The portfolio you choose depends on your situation and your goals. Periodically review your portfolio and determine whether you need to rebalance it to align with your current risk tolerance and time horizon.

Asset allocation can help you achieve appropriate growth for your portfolio while limiting some of your risks. Take the time to consider your investments and your allocation, and you might be surprised at what you can accomplish.

How to Manage Your Asset Allocation Across Multiple Accounts

It’s important to treat your entire investment portfolio as a single bucket when balancing your investments. What do I mean by this?

Let’s say you have 5 different investment accounts – a Thrift Savings Plan, an IRA, a taxable investment account, and your partner’s IRA and 401k.

It’s much easier to balance your entire investment portfolio when you treat it as one large portfolio instead of trying to have 5 separate balanced portfolios inside 5 different accounts.

In this situation, your IRA may have only one index fund instead of a mix of stocks, bonds, cash, and real estate. You can compensate for those assets by giving them greater weight in your other investment accounts.

This method makes it easier to manage and balance your investment portfolio, especially as the number of your investment accounts grows. It’s not uncommon for some people to have 10 or more investment accounts, including taxable accounts, IRAs, rollover IRAs, current 401k plans, former 401k plans they haven’t rolled over yet, Health Savings Accounts that hold investments, and more.

How to Easily Manage Multiple Investment Accounts

An easy way to help you allocate assets across your entire investment portfolio is with a free tool called Empower (formerly Personal Capital). This powerful tool can help you see how your investments work together.

You can learn more in our Personal Capital Review or sign up for a free account at their site.