Investment portfolios: Asset allocation models

How different asset mixes perform

The chart below shows asset mixes and their historical performance. From left to right, it moves from an all-bond allocation to an all-stock allocation. Insights such as best, worst, and average annual returns for each allocation can help you build an investment portfolio that aligns with your goals. 

Why is diversification important in an investment portfolio?

Diversifying your portfolio is one of the best ways to manage risk. Rather than trying to pick potential winners and avoid potential losers, diversification calls for holding a variety of different assets to help increase your chances of long-term success. 

When you keep all your money in one asset class, whether stocks, bonds, or real estate, you risk losing more during market downturns or geopolitical events. A diversified portfolio, on the other hand, spreads your investment across various asset classes to reduce risk. If one drops in value, the others may hold steady or even rise, which can help offset losses and stabilize your portfolio.

Diversification is one of the most fundamental strategies for building an investment portfolio focused on long-term growth.

What is an asset allocation fund?

Asset allocation funds are a convenient way to invest in a diversified portfolio of assets.

An asset allocation fund is a type of mutual fund or ETF (exchange-traded fund) that invests in a mix of different asset classes, such as stocks, bonds, and cash. The fund manager typically allocates a specific percentage of the fund's assets to each asset class and rebalances the portfolio regularly to maintain the desired allocation. Each asset class responds differently to market movement. Holding investments from each one reduces your overall risk, which means your portfolio is designed to be in a better position to weather market ups and downs.

Here are some common types of asset allocation funds:

Target-date funds. These funds are designed to help investors save for retirement. They automatically adjust their asset allocation over time, becoming more conservative as the fund's target date approaches.

Balanced funds. These funds typically invest in a mix of stocks and bonds, with a focus on income and capital appreciation.

Growth funds. These funds invest primarily in stocks, with the goal of generating capital appreciation at a quick rate.

Income funds. These funds invest primarily in bonds and other income-generating assets.

What is an asset allocation model?

Asset allocation funds offer a pre-set, diversified portfolio designed for a hypothetical investor. On the other hand, asset allocation models give you the flexibility to tailor your portfolio to your unique goals, time frame, risk tolerance, and more. While funds are one-size-fits all, models empower you to create a personalized investment mix.

Vanguard has a series of asset allocation models you can choose from to fit your financial goals. These models use Vanguard's proprietary tools, such as the Vanguard Asset Allocation Model (VAAM) and the Vanguard Capital Markets Model®, which project the expected returns and interrelationships of different asset classes over time. They reflect a philosophy of using broadly diversified, low-cost index funds to achieve a prudent risk-return balance.

Income portfolio

An income portfolio consists primarily of dividend-paying stocks, which are stocks from companies that pay out a portion of their profits to their shareholders, and coupon-yielding bonds, which are bonds that pay regular interest to investors. Keep in mind that, depending on the type of account in which these investments are held, dividends and returns can be taxable.

This model can be suitable for anyone who's in or nearing retirement. It can generate a steady stream of income for investors. An income portfolio can also be helpful for someone who's looking to achieve a specific goal, such as a down payment on a house.

Balanced portfolio

A balanced portfolio invests in both stocks and bonds to reduce potential volatility. An investor seeking a balanced portfolio is comfortable tolerating short-term price fluctuations, is willing to accept moderate growth, and has a mid- to long-range investment time horizon. It's an appropriate strategy for many investors who are seeking a comfortable retirement. This allocation model is designed to generate income while also preserving capital. It can work well for investors who want to grow their wealth over time without overextending their risk tolerance.

Growth portfolio

A growth portfolio consists of mostly stocks that are expected to appreciate over the long term and could potentially experience large short-term price fluctuations. An investor considering this portfolio should have a higher risk tolerance and a long-term investment time horizon. Generating current income isn't a primary goal. An investor could use this model to fund a large purchase in the future or grow wealth for retirement. It's the riskiest of the 3 models because it invests in the highest percentage of stocks.

Why should you align your portfolio allocation with your financial goals?

To give yourself the best chance of investment success, it's important to choose an asset allocation model that aligns with your financial goals—how much you'll need, your time horizon, and your risk tolerance.

For a short-term financial goal, such as saving for a down payment on a house, you may want to consider an income portfolio that also aims to preserve your principal investment. Your retirement goals, on the other hand, will have both short- and long-term horizons. When you're in retirement, you'll need some money for daily expenses, but other assets won't be touched for years. For the longer-term portion of those savings, a growth portfolio offering the potential for higher returns in exchange for a higher level of risk could be a better fit.

How to build a diversified investment portfolio

Before choosing investments for your portfolio, understanding your financial goals, risk tolerance, and time horizon can help you design a portfolio that works for you. Here are some steps you can take, and important questions to ask yourself, to align your portfolio allocation with your financial goals.

1. Identify your financial goals

What are you saving for? Do you want to buy a house? Retire early? Pay for your child's education? Once you know your financial goals, you can start to develop a plan to achieve them.

2. Assess your risk tolerance

Understanding your risk tolerance is essential to building an investment portfolio aligned to your goals. When deciding what level of risk is right for you, it comes down to not only what you're comfortable with, but also what you can afford. While you may feel at ease with market volatility and the higher risk that comes with investing in stocks, your financial position may require a more conservative approach that also includes bonds.

Ultimately, the key is to align your asset allocation with both your emotional tolerance and your capacity to absorb potential losses. Striking the right balance helps you stay on track with your goals, even when the market fluctuates.

3. Determine your time horizon

How long do you have to save for your goal? For a short-term goal, a more conservative asset allocation can help protect your savings from market fluctuations. For a long-term goal, you can generally afford to be more aggressive.

Your time frame also affects how much you'll need to save. Let's say you want a $10,000 down payment in 6 years. If you open an account with $100 that earns a 6% average annual return, you'll need to save around $114 a month for 6 years to reach $10,000. All other factors being equal, if you want the same down payment in only 3 years, you'll have to save more than $250 a month.

The timing of your withdrawals is also important. If you're saving for a down payment on a house, for example, you'll likely make one large withdrawal. If you're saving for retirement, you'll spread out your withdrawals over many years.

Note: This hypothetical example does not represent the return on any particular investment and the rate is not guaranteed.

4. Choose your asset allocation

It's important to find the right balance, especially when it comes to asset allocation. It determines how much risk you're exposed to and the pace of your progress. A well-balanced asset allocation can help you ensure your portfolio can weather market storms while still reaching your destination. It's about finding a balance that's likely to achieve your goals in the desired time frame.

5. Choose your investments

Once you've determined your asset allocation, you need to choose the specific investments you want to include in your investment portfolio. A wide variety of investments are available, so it's important to do your research and choose investments that are appropriate for your financial goals and risk tolerance.

6. Rebalance your portfolio regularly

Over time, the performance of different asset classes will vary. This can cause your asset allocation to drift away from your target allocation. To keep your portfolio aligned with your financial goals, you'll need to rebalance it regularly. This can means selling some of the investments that have performed well and investing the proceeds in other asset classes, or adding money to any asset class that's below its target allocation.