Asset allocation is the decision about how much of an investment portfolio to place in each broad asset class, such as stocks, bonds and cash. A typical allocation is written as percentages, for example 60% equities, 35% bonds and 5% cash. Individuals, pension schemes, endowments, insurers and fund managers all set an allocation first and pick individual securities second, because the mix of asset classes does most of the work in deciding how much a portfolio can gain or lose.
Asset allocation is closely tied to diversification, but the two are not the same: allocation sets the proportions between asset classes, while diversification spreads money within and across them. The right allocation depends on the investor's investment objective, time horizon and risk tolerance. In the United States, brokers and advisers who recommend an allocation must follow suitability and best-interest rules; in the UK and EU, the equivalent duties sit in the FCA's conduct rules and MiFID II.
Asset allocation in plain terms
Think of packing for a long trip with weather you cannot predict. You would not fill the case only with swimwear or only with coats. You decide roughly how much space each kind of clothing gets, based on where you are going and how long you will be away, and then you choose the individual items.
Asset allocation is the same first step for money. Before choosing which company shares or which bonds to buy, the investor decides what share of the money goes into growth-seeking assets that can swing a lot, what share goes into steadier assets that pay income, and what share stays in cash for emergencies and near-term bills.
Strategic and tactical asset allocation
Practitioners distinguish two layers of decision:
- Strategic asset allocation. This is the long-term target mix, set from the investor's goals and constraints and usually written into an investment policy statement. A classic example is the "60/40" portfolio of 60% stocks and 40% bonds. The strategic mix changes only when circumstances change, such as approaching retirement.
- Tactical asset allocation. This is a deliberate, temporary move away from the strategic weights, for example holding 65% in stocks for a few months because a manager expects equities to outperform. It is a form of market timing and adds the risk of being wrong.
- Dynamic or glide-path allocation. Some products change the mix on a pre-set schedule. Target-date funds, for instance, hold mostly equities when retirement is far away and shift toward fixed income securities and cash equivalents as the target year approaches.
A ready-made allocation can be bought in a single product. A balanced fund keeps a fixed blend of shares and bonds, while many investors build their own mix from an equity fund, a bond fund and a money market fund, or from low-cost exchange-traded funds.
How the mix is chosen
The starting point is the trade-off between expected return and the size of possible losses, known as the risk–return trade-off. Equities have historically produced higher long-run returns than bonds or cash, with much larger falls along the way. An investor saving for a house deposit in two years cannot afford a 30% drop in the stock market, while a 25-year-old saving for retirement usually can. Other inputs include the need for income, tax treatment, liquidity needs and any rules the investor must follow, such as Sharia screens in Islamic finance.
Institutional investors such as pension funds often use mean–variance optimisation, the method that grew out of Harry Markowitz's 1952 work on portfolio selection, to find the mix with the highest expected return for a chosen level of volatility. They also add alternative assets, including private equity, hedge funds, property and commodities.
A widely cited 1986 study by Gary Brinson, Randolph Hood and Gilbert Beebower, based on 91 large US pension plans, found that investment policy (the long-run allocation) explained on average about 94% of the variation in each plan's quarterly returns over time. The finding is often misquoted as "allocation explains 94% of returns"; it describes how returns moved, not how large they were.
Rebalancing
Markets move the mix without the investor doing anything. If stocks rise strongly, a 60/40 portfolio can drift to 70/30 and carry more risk than intended. Rebalancing means selling some of what has grown and buying what has lagged, or directing new contributions to the under-weight asset class, to restore the target. Common approaches are calendar rebalancing (once or twice a year) and threshold rebalancing (whenever an asset class drifts, say, five percentage points from target). Selling winners in a taxable account can trigger a capital gain, so investors often rebalance inside tax-sheltered accounts such as an individual retirement account (IRA) where possible.
Limitations
Asset allocation rests on estimates of future returns, volatility and correlations, and those estimates are unstable. In 2022, for example, US stocks and bonds fell together as inflation and interest rates rose, so the bond share of 60/40 portfolios gave little protection that year. Rules of thumb such as "hold your age in bonds" are simple but ignore income, other assets and goals. Allocation also cannot remove market risk: a broad decline in all risky assets will still hurt a well-allocated portfolio, only less than a concentrated one.
The term "portfolio allocation" is used in the same sense, sometimes extended to the split between individual holdings as well as asset classes.