Asset allocation: An essential guide

Asset allocation is an important strategy that can assist you in balancing risk and reward within your investment portfolio by helping you determine how much to hold in different asset classes. For most investors, these classes are typically stocks, bonds and cash. These categories apply whether you own stocks and bonds directly or within mutual funds and exchange-traded funds. For each of these asset classes, there are different expected returns and risks.

The asset allocation that's most appropriate for you is shaped mainly by four factors:

• Your financial goals
• Your time horizon or how many years until you need access to the money
• Your comfort with risk — or market volatility — and capacity to take on risk
• How much readily available cash (also called liquidity) you need access to

As a general rule, assets with higher levels of risk are also likely to have the potential for higher anticipated returns, so dividing your portfolio among asset classes gives you the potential to balance both. Stocks are generally the riskiest asset, potentially offering the highest returns along with the greatest volatility. Bonds — especially government bonds — are often considered less risky, delivering smaller returns in exchange for more stability. Cash is thought to be the most stable allocation but with the least likelihood of appreciation and poor protection against inflation. The more risk averse you are, the more you'll want to be invested in "safer" assets like high-quality bonds and cash.

If you're investing for a long-term goal, you may consider taking on more risk with your investments, as you have longer to ride out the inevitable ups and downs of the market. Younger investors saving for retirement 30 years down the road might want a portfolio heavily weighted toward stocks because they believe it may provide greater long-term growth. But as you near retirement and then start living off your investments, you have less time to recoup losses if stock prices drop. So you may decide to invest a greater percentage of your portfolio in bonds and cash.

As you can see with these sample portfolios, you should settle on an asset allocation that is aligned with your own personal tolerance for risk.

Allocating your investments among several asset classes can temper the overall risk in your portfolio. An allocation that balances riskier investments — like growth stocks or shares of smaller companies (called small caps) — with lower-risk investments like high-quality bonds can potentially offer long-term growth, perhaps with less return, without putting your entire portfolio at risk. Historically, bonds tend to move in the opposite direction from stocks, and therefore, having bonds in a portfolio can often help to minimize the effects of a down market.

When markets are volatile, an asset allocation strategy is especially valuable. In fact, by regularly reviewing your portfolio and adjusting it when needed, your portfolio may be less impacted by market volatility. When you have an asset allocation strategy that aligns with your risk tolerance, time horizon and liquidity needs, you'll be more likely to stay the course and keep focused on your goals. Why is that important? History shows that selling assets when they're down can put you at risk of missing out on the subsequent rebounds that have generally followed market declines.

The best days often come soon after the worst and missing out on those days can be costly. For example, from January 1990 to December 2024, the compound annual growth rate of the stock market was 10.7%. But if you excluded the 10 best days in that period, the return dropped to 8.3%, according to an analysis by BofA Global Research.

Diversification means more than spreading your investments across different asset classes; it also involves choosing a broad selection of investments within the various asset classes. Within both stocks and bonds, you can diversify by company size or particular industries — even geography.

Small-cap stocks often offer strong growth potential but with higher risks than other kinds of stocks. Larger, more established companies (called large caps) may not grow as quickly but tend to offer less risk. Having both in your portfolio can be one way of diversifying. And because individual industries respond differently to market conditions, you may want to invest in various sectors, such as energy, technology or financials. Investing in certain mutual funds that contain many different stocks also may help you diversify.