Part 4: Asset Allocation and Investment Strategy

This is part 4 in our “Getting Started Series”. Part 1 on an introduction to investing can be found here , Part 2 on investment account types can be found here and Part 3 on security types and brokers can be found here.


What is Asset Allocation and Why is it Important?


Asset allocation describes how an investor splits up the money in their investment portfolio into certain asset types such as stocks, bonds and cash.

Your asset allocation is one of the most important factors in your investment returns. This has been researched and proven time and time again. Asset allocation is more important than market timing and more important than individual security selection.


In 1986 Gary Brinson published a paper titled “Determinants of Portfolio Performance” (Found here) evaluating the performance of 91 managed pension funds and compared their returns to that of an index.


Brinson has a couple of main points at the end of his research:


  • “What (do the results) imply? (The result) implies that it is the normal asset class weights and the passive asset classes themselves that provide the bulk of return to a portfolio.”


How did attempts at market timing and security selection affect the pension funds returns?


  • “The average plan lost 66 basis points per year in market timing and lost another 36 basis points per year from security selection.”


Brinson’s results have been verified by many others, including Roger G. Ibbotson (found here):



  • “For the long-term, passive investor, the asset allocation decision is by far the most important.”


And more recently by Vanguard (found here):


  • “We find that an investor’s allocation to stocks, bonds, and cash investments is the most important determinant of the return variability and long-term total return level of broadly diversified portfolios with limited market-timing…. Active investment decisions—market-timing and security selection—had relatively little impact on return variation over time.”






In the most recent major stock market decline in 2008, an investor 100% in stocks would have lost the previous 10 years of stock market gains after the market dropped. However, if that investor would have held 50% stocks and 50% bonds they would have had a decent return, as shown below.


The example below shows the affects of different asset allocations over the last 10 years if an investor had $10,000 invested between 2002 and 2012.

(click images below to enlarge)



Whoa – people still use Microsoft Office 98?!?

For this example the returns for “100% stocks” assumes $10,000 invested in the etf: SPY. The return for “100% Bonds” assumes $10,000 investment in the etf: TLT. Prices factor in reinvestment of dividends.


The idea behind asset allocation is similar to that of diversification; only asset allocation is on a larger scale. Instead of just being diversified in multiple stocks, asset allocation ensures your investments are spread out adequately into stocks, bonds, cash or other securities.


It is important to invest in multiple security types in order to reduce the risk in your investment portfolio. During some periods stocks may perform better than bonds. In other periods bonds may out perform stocks (as they have the past decade). You can not predict the market’s future, so you position yourself to be ready for anything.


Consider your local Wal-Mart. They sell both sunglasses and rain jackets, even though both are rarely in demand at the same time. In a perfect world Wal-Mart would only have to sell one or the other and have additional room for other inventory. If it is sunny no one will be buying rain jackets, so they are more than likely losing money with rain jackets on their shelves on sunny days. However Wal-Mart can not predict the weather so they stock both items (diversify). When the weather turns, Wal-Mart is ready to sell what consumers want.


In a perfect investment world an investor could buy stocks when stocks will outperform, and then buy bonds when bonds will outperform. Unfortunately, we all know that can not happen. For the same reason Wal-Mart sells both sunglasses and rain jackets, investors should own both stocks and bonds.




The tough decision comes when selecting just what your allocation to stocks and bonds will be.


Selecting your Asset Allocation


Benjamin Graham, the “Godfather of Value Investing” and mentor of Warren Buffett, gives us his advice in his book “The Intelligent Investor


“We have suggested as a fundamental guiding rule that the investor should never have less than 25% or more than 75% of his funds in common stocks, with a consequent inverse range of between 75% and 25% in bonds.”


This rule keeps the investor sheltered at all times from a drop in either bonds or stocks. As stock prices fall, the investor should slowly increase their allocation into stocks until 75% is reached. The 25% minimum in bonds keeps capital protected, and allows the investor to confidently keep purchasing stocks at lower prices.  Then as stocks increase in price, the investor gradually sells stocks and buys bonds.


Of course the asset allocation for everyone should not be the same. There is a classic rule set to help determine investor’s asset allocation; known as the “age in bonds” rule. Where as the investor ages, a larger and larger percentage of their investments would be allocated to bonds. Under this rule, a 25 year old would be 25% in bonds and 75% stocks, where a 65 year old would be 65% in bonds and 35% in stocks. This rule is popular due to its overall simplicity and because it allocates a larger percentage of an older investor’s capital into the “safe” investment – bonds. The theory is based on historical stock returns – stocks return more than bonds, but are much more volatile (as we saw in 2008 when the stock market dropped more than 50%).


A 25 year old is able to weather a large drop in stocks like we saw in 2008 because he/she has a lifetime of wages to make up for the drop.  Compare the 25 year old’s situation to that of an 80 year old widow who is living off of the interest of $1 million savings. For the 80 year old, a 50% drop in his/her savings with no income to replenish their savings would be disastrous.


This rule is sound in principal, but not a universal truth. Many situations may call for a 25 year old to be heavy in bonds or cash because of saving for a house or wedding. While an older investor with a sizeable savings and many grandchildren may want an allocation higher in stocks in order to potentially pass down a larger inheritance. There are many scenarios to consider; Children, parents financial shape, employment status, marriage status, etc etc.


What is important is that as an investor you consider the risks to your investments. If your investments in stock lose 50% in the next year can you hold out until the market recovers? If  the thought of a temporary reduction of 50% in your stock investments keeps you up at night, you have too much money allocated into stocks.



 Investments to make up your Asset Allocation


There is also more to consider than just your allocation in stocks and bonds. Should an investor use individual stocks or stock funds? Individual bonds or bond funds?

Once again the answer will depend on what type of an investor you consider yourself and how much time you want to devote to your finances.


Investing in individual companies, whether it be their stock or bonds, adds an element of risk to your portfolio. In a large index fund, one individual stock may make up only a fraction of a percent of the fund. If you are holding a large index fund and one company goes bankrupt, your portfolio will hardly be affected. However, if 10% of your portfolio is in a single company’s stock and that company goes under your portfolio will certainly be feeling the pain.

For this reason I think there are a couple rules that an investor must follow if they are going to be adding individual stocks into their portfolio:


  • The investor must to willing to put in a lot of time and effort going through company financials before investing in a company’s stock. Annual reports, 10Ks and 10Qs all need to be reviewed first.



  • No more than 5% of your portfolio in an individual stock. – If you portfolio is $100,000 in total value, you should not hold more than $5,000 in an individual stock.




There is nothing wrong with not wanting to put in the effort to own individual stocks. For many that just want to be passive investors a simple portfolio containing several index funds will work just fine (and still beat a majority of investors!). For those who have the time and motivation to invest in individual stocks or bonds, there is increased risk and potential for increased rewards. will have many articles on selecting the individual stocks right for you, but we will not go into much depth into that topic here.


As a general rule for a beginning investor, you should have very little money invested in individual stocks. Keep a large majority of your investments in index funds until you can spend the time to learn the ins and outs of investing in individual companies. We have many articles on helping you select funds in our “Fund Spotlight Series” found here. Specifically, we have an article comparing some of the most popular S&P 500 index funds here.



 Rebalancing for Greater Returns



Retirement accounts do require a little bit of maintenance through the years to keep your asset allocation on track.


As stocks rise (or fall) and bonds fall (or rise), the weight of stocks and bonds in your portfolio will change. If you start the year with an asset allocation of 75% stocks and 25% bonds and stocks outperform bonds all year, you may end the year at 80% stocks and 20% bonds because the value of your stock holding as increased while the value of your bond holdings has decreased.


This necessary maintenance is called “Rebalancing” and is something that only needs to be done once or at most twice per year. Rebalancing ensures that your asset allocation stays on target. Remember from the beginning of this article that your asset allocation is the primary driver of returns for your portfolio, so keep it in check!


Rebalancing involves simply selling a small portion of your stock exposure and using it to buy bonds when stocks out perform bonds (or vice versa when bonds out perform stocks). This is important for two main reasons:


  • Allows the investor to lock in some profits.


  • Allows the investor additional capital to purchase assets that are becoming cheaper and lightening up their weighting on assets that are becoming more expensive.


Use the most recent 2008 market decline as an example. If an investor would have sold off some bonds in 2008 and used those profits to buy stocks, they would have had exceptional returns from that stock purchase in 2008.

Compare the results of a $10,000 portfolio with asset allocation of 50% stocks and 50% bonds that did not rebalance at all from 2002 to 2012 to a portfolio that rebalanced annually (at the first of the year):




Ending results where:

No Rebalancing – $20,834.83

Rebalancing annually – $23,089.40


A difference of over $2,250 for something that takes only minutes per year to do!


When looking at the data you can see why rebalancing really works. (Click to enlarge)





If an investor did not rebalance through the 2008 market drop, there were times where their asset allocation was not 50%/50% as they might have thought, but really upwards of 65% bonds / 35% stocks because the stock’s value had dropped so much. At a time when stocks were very cheap, the investor was in fact underweight stocks!


By rebalancing at the first of the year, the investor sold off bonds when they were expensive and bought stocks when they were cheap. This allowed the investor to profit much more when the market recovered from 2009 until 2012.


The effects of rebalancing compound year after year. If this example was stretched over 50 years instead of 10, the results would be even more dramatic. Start annual rebalancing in your portfolio now and reap the benefits at retirement.


Lifecycle Funds – The Simplest Strategy Yet


There is also a relatively new type of fund that does the asset allocation and rebalancing for you, and typically at a very reasonable cost. They are called Lifecycle funds, and are available from many fund companies and 401k plans.


Investing in lifecycle funds is hands down the simplest investment strategy today. An investor chooses a lifecycle fund by first estimating the decade they will retire. Lifecycle funds are named by the investor’s target retirement date. For example “Vanguard Lifecycle 2050” is a fund for investors looking at retirement near 2050.


If you buy Vanguard Lifecycle 2050 today, you will notice the asset allocation for the fund is roughly 90% stocks and 10% bonds. (click to enlarge)



As the years go by and the investor is closer to retirement – capital preservation becomes more important and the investor should shift some stock exposure into bonds. Over the years the lifecycle fund will slowly sell stocks and increase holdings in bonds. As an investor you never have to sell the 2050 fund and buy another fund as you age or need to rebalance, the fund automatically changes and adjusts its holdings for you!


Someone who is retiring this decade would be invested in the 2010 or 2020 lifecycle fund. Look at how the asset allocation changes from the 2050 lifecycle fund to the 2010 and 2020.


2020 Lifecycle Fund – 65% stocks 35% bonds: (click to enlarge)



2010 Lifecycle Fund – 44% stocks 54% bonds 2% Cash: (click to enlarge)


Again, this is automatic. 30 years ago the 2020 lifecycle fund (if it existed 30 years ago) was holding roughly 90% stocks and 10% bonds (same % as 2050 fund today). But over time, decreased its holdings in stocks, and increased holdings in bonds. The investor does not have to do anything.
If you want to compare these lifecycle funds with all of Vanguard’s Lifecycle funds of other dates, click here for a full list of Vanguard’s Lifecycle funds.
All this for expense ratios of around .15%! If you are the type of investor who wants a retirement portfolio to simply “set and forget”, there is no better option than lifecycle funds. With an automatic contribution set up to a retirement account with lifecycle funds, the account can run on autopilot for decades.


Lifecycle funds are only one of many options. You may want more control over your investments than just putting all your money in a lifecycle fund. Maybe you want to hold more or less bonds at your age than the lifecycle fund does, maybe you have time to research individual stocks and want to add individual stocks to your portfolio, or maybe you just want to manage your investments yourself. In those cases, lifecycle funds may not be for you.


Lifecycle funds can also be used as a “foundation” of your investment portfolio, but supplemented with other stocks or bonds to achieve the asset allocation you desire.


For example, the asset allocation of the 2050 Lifecycle fund obviously breaks Graham’s “75/25 rule”. If an investor wanted to adhere to Graham’s rule but still own lifecycle funds they may want to purchase the 2050 Lifecycle fund and add an additional bond fund to their portfolio to increase their exposure to bonds.



Keeping up with your asset allocation


Some brokerages and money managers have tools for you that will monitor your asset allocation; however this may not be of much help to the investor because typically an investor has multiple investment accounts. You may have a 401k through one company, while a Roth IRA is at another company.

To combine all accounts and determine an overall asset allocation, I have found the easiest way is to use excel, or any other spreadsheet software to help you out.

I have set up an excel template to help keep my investments and asset allocation organized and straight forward. This is not meant to be investment advice of any kind, only an example that has helped me over the years. My asset allocation may be very different than yours, and that is just fine. What is important is that you as an investor know your specific asset allocation, and the expectations and risks associated with that asset allocation. If there is interest, I can go into detail about how you go about making a template such as this in Excel for your accounts.


(click to enlarge)




Now, when it is time for me to rebalance all I have to do is log into my investment accounts, type in the new value of any new investments (blacked out above) and the percentages (asset allocations) are set with a formula to automatically change and reflect my new asset allocation. If I added $5000 into Vanguard’s Total Bond Fund, all the percentages on the spreadsheet are set to automatically update.


A spreadsheet like this takes about 10 minutes to set up, and requires no maintenance unless brand new stocks or funds are added (I spend about 5 minutes once a month updating it). I have found this to be simpler, cheaper (it’s free!) and more accurate than other services available online.




In Summary


In this getting started series you have gone from simply learning why investing is important, to selecting a broker and account type and now finally how to determine and manage your asset allocation. From here all you have to do is get started.


But this is not where leaves you on your own, this is only the beginning! We offer many more free articles, videos and guides to assist investors on choosing specific investments, maximizing their investing returns and minimizing time required to manage your portfolio.


Don’t stop reading here!


Our Fund Spotlight Series helps you find the best new investments out there.


We have many more articles on budgeting and saving for advice on how to save money so you can increase your savings and investments.


We have posts on investment strategies to ensure that your savings grow and last for retirement.


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