Why Is Asset Allocation Important?

Why Is Asset Allocation Important? The theory behind asset allocation is to spread your investments across different asset classes to help protect your portfolio from downturns in any one asset. Since different investments are affected differently by economic events and market factors, owning different types of investments helps reduce the chances that your portfolio will be adversely affected by a particular risk type. Does asset allocation really accomplish this goal?

To see how asset allocation can help reduce your portfolio's volatility, consider this example. During the period from 1976 to 2005 (30 years), the Standard & Poor's 500 (S&P 500) had an average annual return of 12.7%, while intermediate-term government bonds had an average return of 8.3%. The largest loss sustained in any given year for the S&P 500 was 22.1% in 2002 and 5.1% for intermediate-term bonds in 1994 (Source: Stocks, Bonds, Bills, and Inflation 2006 Yearbook, Ibbotson Associates).* The S&P 500 is used as a measure of common stock returns, since it is an unmanaged index generally considered representative of the U.S. stock market. Keep in mind that stocks and government bonds have different investment characteristics. Stocks can have fluctuating principal and returns based on changing market conditions, while government bonds have fixed principal value and yield if held to maturity and are guaranteed as to the timely payment of principal and interest.

The table below indicates the average annual return and largest one-year loss if varying percentages of these two assets were held:

% owned of S&P 500 % owned of Bonds Average Return Largest Loss
100% 0% 12.7% -22.1%
90 10 12.3 -18.6
80 20 11.8 -15.1
70 30 11.4 -11.6
60 40 10.9 -8.1
50 50 10.5 -4.6
40 60 10.1 -2.5
30 70 9.6 -3.2
20 80 9.2 -3.8
10 90 8.7 -4.5
0 100 8.3 -5.1

To obtain the highest average return, you must invest totally in the highest performing asset, but that asset also has the potential for the greatest loss. The smallest one-year loss was incurred by owning 40% stocks and 60% bonds. However, don't simply look at the least risky combination, since you are also giving up return for that reduction in risk. While a percentage or two may not seem like much, it can have a significant impact on your portfolio's value over a long time period.

While each person's asset allocation strategy will be unique, consider these points:
  • Invest in both stocks and bonds.
    Stocks tend to have a low positive correlation with corporate and government bonds, meaning on average, movements in stock prices will only moderately impact movements in bond prices. Thus, owning both, as the example above shows, reduces your portfolio's volatility.

  • Consider increasing your stock allocation for long time horizons.
    By staying in the market through different market cycles, you reduce the risk that market volatility will adversely affect your portfolio's performance.

  • Diversify within, as well as among, investment classes.
    For instance, in the stock category, consider value and growth stocks as well as small- and large-capitalization stocks.

  • Rebalance your portfolio at least annually.
    Since your strategy is designed to provide a stable risk exposure, it must be periodically rebalanced so the allocation does not get out of line.

  • Keep sufficient cash on hand for short-term needs.
    That way, you won't have to sell investments during market downturns.

  • Evaluate new investments carefully, ensuring they add diversification benefits to your portfolio.
    Don't keep adding similar investments, such as several stocks in the same industry. Not only does this not add much in the way of diversification, but it also makes your portfolio more difficult to monitor.
* Past performance is not a guarantee of future results. Returns are presented for illustrative purposes only and are not intended to project the performance of a specific investment vehicle.

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