How to Achieve Optimal Asset Allocation: A Guide to Building a Balanced Investment Portfolio

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Asset allocation is a way for investors to meet their financial objectives while keeping their risk in check and ensuring they remain on the right path to reach their goals. While there are many “standard” or “sample” types of asset allocation, each investor should spend the time to build an asset allocation that reflects their personal financial situation and needs, rather than simply following some suggested asset allocation.

By weaving together the right blend of correlating and non-correlating assets, as explained below, investors can create the best asset allocation for them. Here’s a look at all of the ins and outs of portfolio asset allocation, including the pros and cons of various asset allocation models and the steps you need to take to build the right blend for you.

What Is Asset Allocation?

Asset allocation refers to how investors divide their portfolio into different asset classes, such as bonds and stocks. An asset allocation is essentially a financial road map that guides investors as to where to put their money based on their own investment objectives, risk tolerance and time horizon.

The idea behind asset allocation is that investors can create portfolios that balance their own personal preferences for risk and reward. A good asset allocation, for example, will diversify a portfolio to reduce its overall risk while still maintaining its upside potential. But there are different types of asset allocation, and different ways for investors to meet these goals. This is why it’s important to understand exactly how asset allocation works and why it matters. 

Why Optimal Asset Allocation Matters

An optimized asset allocation is one that manages to achieve the highest possible level of potential return for a given amount of risk. This blend will vary from investor to investor because they each have their own unique balance of risk and reward. Some investors, for example, are willing to accept a potential 50% drop in the value of their portfolio in exchange for the chance at greater upside, while others simply want to preserve the money they invested and are willing to accept lower returns to achieve that. 

However, regardless of how aggressive or conservative an investor you are, there’s always a point at which potential return and possible risk are blended at the optimal point, and that is the goal of any good asset allocation. The idea is to manage your risk as best as possible – even for an aggressive investor – while still maintaining your upside potential. 

Non-Correlated Assets

This can be achieved by combining various assets that have different risk/reward characteristics and that don’t necessarily move in the same direction at the same time – meaning, they are non-correlated. Bonds and stocks, for example, are often blended in asset allocations for a number of reasons. For one thing, bonds are much less volatile than stocks.

From 1989 through 2021, for example, bond volatility ranged from 1.6% to 6.6%, while stocks ranged from 5.2% to 41.4%, exhibiting much greater price swings. And while bonds and stocks sometimes had positive correlation, meaning they moved more or less in the same direction, they often had negative correlation, with price movements in the opposite direction. Both varying levels of volatility and non-correlated price action can help dampen the swings in value of an overall portfolio, thereby minimizing risk while maintaining potential return.

Key Factors Influencing Asset Allocation

There are three primary factors influencing asset allocation: risk tolerance, time horizon, and investment goals. Here’s the breakdown of each of these factors:

Risk Tolerance

The U.S. Securities and Exchange Commission defines risk tolerance as “An investor’s ability and willingness to lose some or all of an investment in exchange for greater potential returns.” In other words, it defines how much of a loss you’re willing to handle in your quest for higher returns.

An important thing to understand about risk tolerance, however, is the investors often think they can handle more risk than they can. It can be easy to say, for example, that you’ll willingly trade the risk of a 30% loss for the potential of a 30% gain, but when your entire portfolio drops by a large amount, you may find that you can’t tolerate that type of loss after all. This is why many financial experts recommend that you build an asset allocation that “lets you sleep at night,” meaning you aren’t kept awake by the stress of the losses in your account.

Time Horizon

Your time horizon, as defined by the SEC, is “the number of months, years, or decades you need to invest to achieve your financial goal.” For example, if you’re 20 years old and investing for retirement, your time horizon is like 40 years or more. But if you’re 30 and saving for your 8-year-old’s college education, your time horizon might be closer to 10 years.

Time horizon is important because the longer it is, the more you can use an aggressive asset allocation, as time smooths out portfolio volatility. Even the U.S. stock market, for example, has never had a 20-year period in which it experienced a loss, in spite of its day-to-day volatility.

Investment Goals

Your investment goals influence both your asset allocation and your specific security selection. For example, if you’re a young person saving for retirement, you can usually benefit from a stock-heavy asset allocation because your objective is growth and you have the time to ride out the ups and downs of the stock market.

But if you’re older and looking for income to fund your lifestyle, you’ll naturally gravitate to a more conservative asset allocation that relies on bonds, dividend-paying stocks or other income-producing investments.

Types of Asset Classes

While there are all types of investments, there are four primary asset classes: equities, bonds, alternative investments, and cash and cash equivalents. Here are the basic definitions of these four pillars:

• Equities: Equities is an industry term for stocks. 
• Bonds: Bonds are income-producing investments that make regular interest payments and promise the return of principal at maturity. They’re generally more conservative than equities.
• Cash and cash equivalents: Cash and cash equivalents range from the money in your savings account to short-term, liquid investments like Treasury bills.
• Alternative investments: Alternative investments run the gamut from commodities like oil and precious metals to hedge funds, private equity and numerous other types of non-correlated assets. 

Steps To Achieve Optimal Asset Allocation

Building the perfect asset allocation for you requires taking specific steps. Here’s the path you should follow:

1. Assess Your Current Financial Situation

Without an understanding of your current financial situation, you won’t be able to properly build an asset allocation. Your starting point will be quite different if you’re in debt and living paycheck to paycheck vs. if you’ve already got substantial cash reserves, for example.

2. Define Your Investment Objectives

As the saying goes, you can’t arrive at your destination until you know where you’re going. If your investment objective is to generate enough income to live off, for example, your asset allocation will be very different from someone looking to maximize capital gains.

3. Determine Risk Tolerance and Time Horizon

Everyone wants to earn as much money as possible off their investments. But you’ll have to balance this quest for riches with a realistic assessment of how much risk you can handle. 

Your time horizon will help point you to the types of investments you should own to reach your financial objectives. If you plan to withdraw your money in the next few years, for example, you should likely have a much smaller allocation to equities than if you’re saving for multiple decades. 

4. Choose the Right Mix of Asset Classes

Ultimately, an asset allocation is simply a balance of different types of investments. But the right mix for you will depend on all of the above factors, from your investment objectives and time horizon to your risk tolerance. The concept is to blend investments that can provide you with a sufficient return while keeping your risk at an appropriate level. 

Rebalancing Your Portfolio

Even the most perfectly balanced portfolio needs rebalancing from time to time. This is because different asset classes tend to outperform one another over various periods of time. If you have a moderate asset allocation consisting of 60% stocks and 40% bonds, for example, a big year in the stock market could push your allocation to 70%/30% instead. Over time, if your asset allocation gets out of whack, your portfolio will no longer have the risk/reward characteristics that you originally intended. 

According to Vanguard, there are risks to balancing both too frequently – such as every month or quarter – or too infrequently – such as every two years. The well-regarded financial services firm suggests rebalancing a portfolio annually for the best results.

Tools and Resources for Asset Allocation

There are numerous tools available to assist you in planning your asset allocation. You can start the process by gathering information and using online tools from reputable sources, such as well-known financial services firms. 

To actually invest your money, you can start with a robo-advisor, which will create an asset allocation on your behalf using AI and invest the money in various mutual funds and/or ETFs. For a more personalized touch, you can work directly with a financial advisor, who can add a personal touch and specialized recommendations based on years of experience.

The Bottom Line

An optimal asset allocation can reduce the risk in your portfolio while maintaining your potential for high returns. It also serves as a good road map to keep your investments on track throughout your lifetime. Rebalancing your portfolio annually and making small adjustments as you age or your objectives change is a good way to help you reach all of your investment goals.

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