An asset allo­ca­tion is con­structed accord­ing to the investors risk tol­er­ance, goals, invest­ment time frame and other fac­tors. Each asset class in the port­fo­lio class is assigned a desired or “tar­get” percentage.

Asset allo­ca­tion is crit­i­cal to per­for­mance: in fact it explains 92% of invest­ment returns (William Sharpe, Stan­ford Uni­ver­sity, 1992). So, how does one choose a proper asset allo­ca­tion? The good news is that numer­ous experts have pub­lished their asset allo­ca­tions; we’ve com­piled a num­ber of them in our book. But there is no such thing as a per­fect allo­ca­tion, a real­ity we reflect upon in our analy­sis of expert allocations.

Here is an exam­ple of a ‘rea­son­able’ asset allo­ca­tion, diver­si­fied across equi­ties and fixed income, in this case 60% equi­ties and 40% fixed income, and is addi­tion­ally diver­si­fied within these two asset classes:

In index invest­ing, each asset class is rep­re­sented by one of more index mutual funds or Exchange Traded Funds (ETFs). For exam­ple, the Van­guard 500 Index Fund Investor Shares belongs in the US large cap asset class, while DFA Inter­na­tional Small Cap Value belongs in the inter­na­tional small value asset class.

Over time, the under­ly­ing funds grow and decline at dif­fer­ent rates, caus­ing port­fo­lios to drift from their ideal allo­ca­tion per­cent­ages. To main­tain a con­sis­tent level of risk, knowl­edge­able investors ‘rebal­ance’ their port­fo­lio to bring the port­fo­lio back in line with the orig­i­nal per­cent­ages. See port­fo­lio rebal­anc­ing.

Most peo­ple have more than one account. For exam­ple, a mar­ried cou­ple could eas­ily have 3 accounts: a tra­di­tional IRA and a Roth IRA and a joint tax­able account or trust. There are very com­pelling rea­sons to view all of a family’s invest­ment accounts as part of a sin­gle port­fo­lio, which we dis­cuss in tax advan­taged rebal­anc­ing.

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3 factor has con­ducted exten­sive analy­sis con­cern­ing port­fo­lio per­for­mance. See “3 factor’s Method­ol­ogy and Invest­ment Risks” for details and dis­claimers regard­ing our state­ments con­cern­ing per­for­mance, and the var­i­ous assump­tions we have made in our analysis.  Past per­for­mance is not a pre­dic­tor of future performance.