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Investing strategies

What is asset allocation? | Vanguard

Learn about asset allocation with Vanguard. Discover how to diversify your investments effectively to balance risk and achieve your financial goals.
5 minute read

Points to know

  • If you start building your portfolio by finding the right mix of asset types, you'll have more control over how risky your portfolio is.
  • There are no "good" or "bad" allocations—you'll need to find the one that's right for you based on your own situation.

How investing is like the weather

Imagine you're relocating and you prefer sunny, dry weather. How will you make sure you pick a new home in a place you're going to enjoy? Just checking today's weather won't tell you much. To know whether a certain location meets your needs, you'd have to understand more about its overall climate.

Start with your climate, not your 5-day forecast

Asset allocation—the way you divide your portfolio among asset classes—is the first thing you should consider when getting ready to purchase investments, because it has the biggest effect on the way your portfolio will act.

Just like it's not a great idea to base your relocation on a current run of nice weather in a random city, choosing investments on a whim is unlikely to be a winning strategy over the long term.

Different asset classes tend to act in specific ways, kind of like the investing climate they inhabit. By choosing how to divide your portfolio, you have a certain amount of control over the experience you'll have as an investor.

There's no "best" asset allocation, just like there's no "perfect" climate for everyone—it all depends on what makes you comfortable and gives you a good shot at meeting your goals.

See more about the risks of different investment types

Asset class

General categories of investments. The three major asset classes are cash investments, bonds, and stocks.

Portfolio

All the securities held by a mutual fund or the total investment holdings of an individual or an institution.

How important is asset allocation?

Extensive research has shown that, if you have a diversified portfolio, a whopping 88% of your experience (the volatility you encounter and the returns you earn) can be traced back to your asset allocation.*

In other words, your experience will be very consistent with that of any other diversified investor with the same asset allocation, no matter which specific investments they choose.

In the same way, if you move to San Diego, your overall weather will be very similar to that of someone living in Los Angeles. It won't matter very much which of those cities you choose or what month you move there—what's important is that you're living in Southern California and not New England.

Diversification

The strategy of investing in different asset classes and among the securities of many issuers in an attempt to lower overall investment risk.

Volatility

 The degree of fluctuation in the value of a security, mutual fund, or index, volatility is often expressed as a mathematical measure such as a standard deviation or beta. The greater a fund's volatility, the wider the fluctuations between its high and low prices.

Return

The gain or loss on an investment. A positive return indicates a gain, and a negative return indicates a loss.

Once I know my asset allocation, what's next?

Within the broad categories of stocks and bonds, there are many subtypes that have specific characteristics. Depending on your goal, you may choose to invest in some of these specific subtypes.

Use stocks to add the opportunity for growth

Use bonds for income & additional stability

Whichever investments you choose, it's important to make sure you lower your risk through diversification.

See how diversification protects you

Bond

A debt security (IOU) issued by a corporation, government, or government agency in exchange for the money the bondholder lends it. In most instances, the issuer agrees to pay back the loan by a specific date and make regular interest payments until that date.

Stock

A security that represents part ownership, or equity, in a corporation. Each share of stock is a proportional stake in the corporation's assets and profits, some of which could be paid out as dividends.

Risk

The potential to lose money (principal and any earnings) or not to make money on an investment.

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*Source: Vanguard, The Global Case for Strategic Asset Allocation (Wallick et al., 2012).

Diversification does not ensure a profit or protect against a loss. Please remember that all investments involve some risk. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.