What Is Asset Allocation?

Definition

Asset allocation is a investment strategy that involves dividing a portfolio's investments among different asset classes, such as stocks, bonds, and commodities, to achieve a desired level of risk and return, a concept rooted in Harry Markowitz's modern portfolio theory, 1952.

How It Works

Asset allocation works by assigning a percentage of a portfolio's total value to each asset class, based on the investor's risk tolerance, investment goals, and time horizon. For instance, a conservative investor may allocate 60% of their portfolio to bonds and 40% to stocks, while an aggressive investor may allocate 80% to stocks and 20% to bonds. The efficient frontier model, developed by Markowitz, is often used to determine the optimal asset allocation, as it identifies the portfolio with the highest expected return for a given level of risk. According to Markowitz's model, a portfolio with a mix of 60% stocks and 40% bonds can provide a return of around 8% per annum, with a standard deviation of 12% (Markowitz, 1952).

The asset allocation process also involves considering the correlation between different asset classes, as investments with low correlation can help reduce portfolio risk. For example, stocks and bonds tend to have a low correlation, as when stock prices fall, bond prices often rise. The Capital Asset Pricing Model (CAPM), developed by William Sharpe, 1964, is another framework used to determine the expected return of an asset based on its beta, or systematic risk. By understanding the relationships between different asset classes and their expected returns, investors can create a diversified portfolio that meets their investment objectives. Boeing, for example, has a pension fund with ~$50 billion in assets, which is allocated across various asset classes, including stocks, bonds, and real estate (Boeing annual report).

The life-cycle model of investment, developed by Ando and Modigliani, 1963, is another approach to asset allocation, which suggests that investors should adjust their asset allocation based on their age and investment horizon. According to this model, younger investors should allocate a larger portion of their portfolio to stocks, as they have a longer time horizon and can withstand more risk. As investors approach retirement, they should shift their allocation to more conservative investments, such as bonds, to reduce risk and preserve capital. The Social Security Trust Fund, for example, has a life-cycle approach to investment, with a mix of stocks and bonds that is adjusted based on the fund's projected cash flows and liabilities (Social Security Administration).

Key Components

• Risk tolerance: the investor's ability to withstand losses in their portfolio, which affects the allocation to different asset classes, such as stocks, bonds, and commodities.
• Investment horizon: the length of time the investor has to achieve their investment goals, which influences the allocation to asset classes with different expected returns and risks.
• Diversification: the spreading of investments across different asset classes to reduce portfolio risk, which can be achieved through a mix of stocks, bonds, and alternative investments, such as real estate and commodities.
• Rebalancing: the periodic adjustment of the portfolio's asset allocation to maintain the target mix, which is necessary to ensure that the portfolio remains aligned with the investor's risk tolerance and investment goals.
• Tax efficiency: the consideration of tax implications when making investment decisions, such as the tax benefits of tax-loss harvesting, which can help reduce the investor's tax liability and increase their after-tax returns.
• Fees and expenses: the costs associated with investing, such as management fees and trading costs, which can eat into the investor's returns and affect the overall performance of the portfolio.

Common Misconceptions

• Myth: Asset allocation is only for institutional investors — Fact: Individual investors can also benefit from asset allocation, as it can help them manage risk and achieve their investment goals, as demonstrated by the success of target-date funds, which have become a popular investment option for individual investors.
• Myth: Asset allocation is a one-time process — Fact: Asset allocation requires periodic rebalancing to maintain the target mix, as market fluctuations can cause the portfolio's asset allocation to drift away from the target, as seen in the 2008 financial crisis, when many investors were forced to rebalance their portfolios to maintain their target asset allocation.
• Myth: Asset allocation is only about stocks and bonds — Fact: Asset allocation can include a wide range of asset classes, such as commodities, real estate, and alternative investments, which can provide diversification benefits and help investors achieve their investment objectives, as demonstrated by the success of the Yale Endowment, which has a diversified portfolio with a mix of traditional and alternative investments.
• Myth: Asset allocation guarantees returns — Fact: Asset allocation can help manage risk, but it does not guarantee returns, as investment returns are subject to market fluctuations and other factors, such as the performance of the underlying assets, as seen in the 2020 market downturn, when many investors experienced significant losses despite having a diversified portfolio.

In Practice

The California Public Employees' Retirement System (CalPERS), one of the largest pension funds in the world, with ~$400 billion in assets, has a diversified asset allocation that includes a mix of stocks, bonds, and alternative investments, such as real estate and private equity. The fund's asset allocation is designed to meet its long-term investment objectives, which include providing a return of at least 7% per annum to support the retirement benefits of its members. To achieve this objective, CalPERS has a target asset allocation of 50% stocks, 25% bonds, and 25% alternative investments, which is periodically rebalanced to maintain the target mix. The fund's investment portfolio is managed by a team of experienced investment professionals, who use a combination of active and passive management strategies to maximize returns and minimize risk. According to CalPERS' annual report, the fund's investment portfolio has generated an average return of around 8% per annum over the past 10 years, with a standard deviation of 12% (CalPERS annual report).