Asset allocation is the investment strategy of dividing a portfolio among different asset classes — such as stocks, bonds, and cash — based on an investor's goals, risk tolerance, and time horizon.
Major asset classes: - Equities (stocks): Higher expected return, higher risk, higher volatility. - Fixed income (bonds): Lower expected return, lower risk, income-generating. - Cash and equivalents: Lowest risk and return; provides liquidity. - Real assets: Real estate, commodities, infrastructure — often inflation hedges. - Alternative investments: Hedge funds, private equity, private credit.
Why asset allocation matters: Studies (Brinson, Hood, Beebower) suggest asset allocation accounts for approximately 90% of the variation in long-term portfolio returns — more than security selection or market timing.
Three approaches:
| Approach | Description | |---|---| | Strategic | Long-term target allocation; periodically rebalanced | | Tactical | Short-term deviations from strategic allocation based on market views | | Dynamic | Rules-based adjustments (e.g., target-date funds glide path) |
Rebalancing: Restoring the portfolio to its target allocation after drift. E.g., if stocks rise from 60% to 70% target, sell stocks/buy bonds to return to 60/40.
Risk considerations: Younger investors with long time horizons typically hold more equities; older investors near retirement typically shift toward bonds (capital preservation).
> Exam tip: Asset allocation drives most of long-term portfolio performance. Rebalancing is the process of restoring target weights — it involves selling winners and buying laggards. For CFP®/Series 65, know the difference between strategic, tactical, and dynamic allocation.