Asset allocation: An essential guide

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Answers to your key questions about this important strategy for reducing risk in your investment portfolio and staying on track to meet your goals.

When the markets are performing well, most people feel confident in their investing strategy. But when markets turn, it can be easy to panic. That's when your asset allocation strategy — or the percentage of your portfolio you've chosen to devote to different assets such as stocks, bonds and cash — can provide useful perspective. "Your long term asset allocation strategy acts as a roadmap to help guide you through every kind of market," says Marci McGregor, head of CIO Portfolio Strategy, Chief Investment Office, Merrill and Bank of America Private Bank. Here, McGregor answers your most common questions about this strategy and how to implement it.

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What is asset allocation?

Asset allocation is an important strategy that can help you to balance 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.

Combining these assets in a way that provides your portfolio with both the possibility of growth and potential protection against loss can help you weather market highs and lows as you pursue your financial goals. Although asset allocation does not ensure a profit or protect against losses in declining markets, careful asset allocation is an important aspect of long-term investing.

How do you determine the proper asset allocation?

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 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.

Examples of asset allocation based on your comfort with risk.

Source: Chief Investment Office, March 2023.

The allocations of the hypothetical investment are for illustration only and do not constitute investment advice. They are being shown to illustrate how a portfolio changes over time. You should consider the number of years until you retire, your goals and risk tolerance. The stock and bond fund allocations will vary for each portfolio depending on the number of years both before and after the planned retirement. Asset allocation cannot eliminate risk of fluctuating prices and uncertain returns.

What are the benefits of asset allocation?

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.

How risky are your funds?

The following investment categories are listed from left to right in order from those having the lowest risk and potential return to those having the highest risk and potential return: Cash equivalents, fixed income funds, large-cap equity funds, mid-cap equity funds, international equity funds (developed countries), small-cap equity funds, international equity funds (emerging countries).

This chart is intended to provide a general evaluation of the risk and potential return of each investment category. It is not meant to predict future performance or the volatility of any asset category.

When markets are volatile, an asset allocation strategy is especially valuable. In fact, by regularly reviewing your portfolio you may experience less 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 always followed market declines.

The best days often come soon after the worst and missing out on those days can be costly. For example, from 1990 to September 2023, the compound annual growth rate of the stock market was 10.0%. But if you excluded the 10 best days in that period, the return dropped to 7.5%, according to an analysis by BofA Global Research.

Time in the market matters

Excluding the best days of stock market performance drastically cuts down returns.

Less time in the market can drastically cut down returns when excluding the best days of stock market performance. These returns are based on S and P 500 Compound Annual Growth Rate, January 1, 1990, to September 15, 2023: fully invested with no missed days yields 10.0%; less 5 best performance days yields 8.6%; less 10 best performance days yields 7.5%; less 20 best performance days yields 5.8%; less 30 best performance days yields 4.4%; less 40 best performance days yields 3.2%; less 50 best performance days yields 2.0%.

Source: Bloomberg, Chief Investment Office. Data as of September 15, 2023.

FOR INFORMATIONAL PURPOSES ONLY. Data reflects S&P 500 Total Return Index performance going back to 1990 incrementally omitting top performing days. Indexes are unmanaged and do not take into account fees or expenses. It is not possible to invest directly in an index. Past performance is no guarantee of future results.

Is diversification the same as asset allocation?

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.

Within the universe of bonds, there are different sectors with varying degrees of risk, from U.S. Treasury bonds (low risk) to investment-grade corporate bonds (a bit riskier) to high-yield bonds (with risk often comparable to stocks). You also might want to consider geographic diversification by adding in some bonds from outside the United States. Each of these types of bonds offers different fee and expense structures and potentially higher or lower returns, depending on their level of risk.

Why is it important to periodically revisit your asset allocation strategy?

Asset allocation is not a set-it-and-forget-it process. Over time, as some of your investments do better than others, your portfolio will naturally "drift" from your initial target allocation, favoring assets that have been experiencing stronger returns. That's why it's a good idea to revisit your portfolio regularly and see whether you need to make changes to reset it to its original proportions — a process known as rebalancing.

How your asset allocation could change over time

Consider a somewhat cautious investor who, at the end of 2008, chose a "moderate" level of risk for her portfolio. Even with the dramatic decline in the stock market in March 2020, by March 2023 her allocations and risk level differed from her preferred allocation. This exposes her to more risk than she's comfortable with.

On December 31, 2008, her asset allocation was 35% bonds, 5% cash, and 60% stocks, with a medium risk level. On March 31, 2023, her asset allocation was now 41% bonds, 1% cash, and 58% stocks, with an increased medium high risk level.

Source: Chief Investment Office, March 2023

Periodic rebalancing can help keep your portfolio in line with your target asset allocation and the goals you want to achieve, and it can help you make more measured decisions about when to buy and sell investments, as opposed to trying to time the market. You can rebalance on a set schedule, reviewing your allocation every quarter, say, or annually — what's known as periodic rebalancing. Or you can rebalance whenever an asset strays beyond a given range — if, for example, an asset moves more than 5% from your target allocation. That's known as tolerance band rebalancing.

Over the long term, rebalancing can potentially help reduce volatility in your portfolio. An analysis by the Chief Investment Office found that from 1992 to 2020, a portfolio of 50% stocks (represented by the S&P 500 Total Return Index) and 50% bonds (represented by the Bloomberg U.S. Aggregate Total Return Bond Index) that was rebalanced annually was about 20% less volatile than a portfolio that wasn't rebalanced.

Arriving at an asset allocation you feel is appropriate for your situation takes time and planning. But given what's at stake, that's likely time very well spent. Asset allocation is a way of instilling discipline in a part of our lives that we often find very stressful. If you can reduce that stress, it improves the odds that you will stick to your long-term goals.

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Merrill, its affiliates, and financial advisors do not provide legal, tax, or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions.

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