Much like the process of building a house, an investor must consider various factors before they begin putting together a suitable investment portfolio. Before laying the foundation, a well thought out design is needed that aligns with the needs and preferences of the homeowner. Similarly, before making any investments, it’s important to determine and understand how much risk an investor is comfortable with and what return they are aiming for. Just as choosing the right layout is crucial for a functional home, selecting the right asset allocation is essential for a sound investment portfolio.

In this article we’ll review the basic tenets of asset allocation and why it’s important for long-term investment success.

Asset allocation is the process of dividing up an investment portfolio across various asset classes—the most common including stocks, bonds, and cash. An appropriate asset allocation serves as the blueprint for your investment framework and involves determining how different investments fit together to create a balanced and resilient portfolio. Different types of asset classes come with different risk and return characteristics and can perform differently under the same market conditions. By spreading investments across various asset classes, an investor can tailor their portfolio’s potential risk and return profile to best align with their risk tolerance, financial circumstances, and goals. 

Research has consistently shown that the mix of asset classes within a portfolio is by far the greatest determinant of both total returns and return variability over the long term. In fact, many studies suggest that over time, more than 90% of a portfolio’s return variability can be explained by its asset mix.¹

Given the importance of asset allocation in guiding expected returns and risk, investors need to exercise care and attention in selecting a personalized asset allocation for their portfolio. This personalized asset allocation is referred to as an investor’s strategic asset allocation and should consider factors like an individual’s risk tolerance, return objectives and investment time horizons. 

An investor’s risk tolerance—or their willingness to assume unknown and potentially negative returns—is a primary factor in selecting an appropriate asset allocation as it helps investors choose a mix of investments within their comfort level. This can temper the discomfort that may arise during periods of market volatility and lead to poor investment decisions and financial setbacks. Matching asset allocation to risk tolerance is essential for maintaining a portfolio that an investor can stick with through market cycles, which ultimately puts them in the best position to achieve their financial goals.

Beyond risk tolerance, factors like an investor’s time horizon and investment objectives can heavily influence asset allocation decisions. The length of time an investor has until they need to access their funds (their time horizon) affects how much risk they can afford to take. Longer time horizons generally allow for more aggressive and stock-intensive asset allocations because there is more time to recover from potential market downturns.

For instance, an investor drawing on their investments in retirement might prioritize capital preservation and income generation which may involve a more conservative asset allocation with a greater proportion of less risky investments such as bonds, cash and large dividend-paying stocks. In contrast, someone saving for a young child's education with a long time horizon may have a greater focus on growth, and so choose a more aggressive asset mix that includes a greater proportion of stocks.

Since risks and returns are inextricably linked, an appropriate strategic asset allocation can align a portfolio’s risk and return profile with the investor’s unique comfort level, circumstances and goals. This can help ensure that it achieves the highest possible return given the desired level of risk.

Additionally, a well-considered asset allocation contributes to effective risk management through diversification. Diversification involves strategically spreading investments across various asset classes to reduce the impact of poor performance in any single area. Diversification can be extended further by including securities with different attributes within each asset class. For example, within stocks, this can involve including companies across different sectors of the economy, geographies, and market capitalizations or sizes. In a diversified portfolio, the positive performance of some investments can offset the negative performance of others, which can help reduce overall portfolio volatility.

When an investor determines a suitable strategic asset allocation that aligns with their goals and risk profile, it fosters consistency and discipline in their investment approach. A well-structured portfolio helps investors avoid making impulsive decisions based on market fluctuations. Instead of reacting emotionally to market ups and downs, a solid strategic asset allocation encourages investors to stick to their strategy, increasing the likelihood of better long-term outcomes and fewer poor decisions driven by short-term market movements.