You have learned about . Now comes the next question: how much should you put in stocks vs. bonds vs. other investments? This is called , and it is one of the most important decisions you will make as an investor.
Why Matters
Studies suggest that asset allocation explains about 90% of the variation in portfolio returns over time. Not which stocks you pick. Not timing the market. Just the basic split between different types of investments.
Pro Tip
Think of asset allocation like a recipe. The ingredients (stocks, bonds, etc.) each play a role. Too much of one thing throws off the whole dish.
The Main Ingredients
Stocks (Equities)
- Role: Growth engine of your portfolio
- Risk: High—can lose 30-50% in bad years
- Reward: Historically ~10% average annual returns
- Best for: Long-term goals (10+ years away)
Bonds (Fixed Income)
- Role: Stability and income
- Risk: Lower—typically lose less in downturns
- Reward: Historically ~5% average annual returns
- Best for: Near-term goals, reducing volatility
Cash and Cash Equivalents
- Role: Emergency fund, short-term needs
- Risk: Very low
- Reward: Currently 4-5% in high-yield savings accounts
- Best for: Money you need within 1-2 years
Classic Allocation Strategies
Age-Based Rule
A simple starting point: subtract your age from 110 to get your stock percentage.
- Age 25: 85% stocks, 15% bonds
- Age 40: 70% stocks, 30% bonds
- Age 60: 50% stocks, 50% bonds
This rule exists because younger investors have more time to recover from market crashes. A 25-year-old losing 40% is painful but recoverable. A 65-year-old losing 40% right before retirement is devastating.
Target Date Funds
If you want a "set it and forget it" approach, target date funds do the allocation for you. Pick your expected retirement year, and the fund automatically adjusts from aggressive to conservative as you age.
Example: A "2055 Target Date Fund" starts aggressive (90% stocks) and gradually shifts to conservative (40% stocks) as 2055 approaches.
Three-Fund Portfolio
A popular DIY approach using just three funds:
- U.S. Total Index (50-60%)
- International Stock Index (20-30%)
- U.S. Index (10-30%)
This gives you exposure to thousands of companies worldwide plus bond stability.
Factors That Affect Your Allocation
Time Horizon
| Goal | Timeline | Stock Allocation |
|---|---|---|
| Emergency fund | Now | 0% |
| House | 2-3 years | 0-20% |
| Kids' college | 10 years | 50-70% |
| Retirement | 30 years | 80-100% |
Risk Tolerance
Be honest with yourself. If a 30% drop would cause you to panic-sell, you need more bonds—even if the math says you can handle more stocks.
Avoid This
Do not test your risk tolerance during a bull market. Everyone thinks they can handle a crash until it happens. If you have never experienced a real bear market, be more conservative than you think you need to be.
Other Income Sources
If you have a pension or expect significant Social Security, you already have "bond-like" income. This might allow you to hold more stocks in your portfolio.
Rebalancing: Keeping Your Allocation on Track
Over time, your allocation drifts. If stocks do well, they become a larger percentage of your portfolio than intended.
Example:
- Start: 80% stocks, 20% bonds
- After a good year: 85% stocks, 15% bonds
- Rebalance: Sell some stocks, buy bonds to return to 80/20
How often to rebalance:
- Once a year is usually enough
- Or when allocation drifts by more than 5%
Do This
Many plans offer automatic rebalancing. Turn it on and never think about it again.
International
U.S. stocks have dominated recently, but that is not always the case. International stocks:
- Provide diversification if U.S. markets struggle
- Expose you to faster-growing economies
- May be cheaper than U.S. stocks at times
A common allocation: 60-80% U.S. stocks, 20-40% international stocks.
The Bottom Line
Quick Win
If you are overwhelmed, pick a target date fund matching your retirement year. It handles asset allocation automatically. You can always refine your approach later as you learn more.
Asset allocation is not about maximizing returns—it is about maximizing the returns you can actually stick with through market ups and downs.