The Importance of Asset Class Allocation

Individual investors can choose from a variety of asset classes, including stocks, bonds, commodities, options, real estate, art, stamps, coins, antiques and other collectibles. We will limit our discussion here to stocks and bonds, which have the advantages of low transaction costs and high liquidity.

Asset class allocation refers to how assets are allocated within a portfolio. Empirical research has shown that asset allocation decisions account for about 94% of portfolio performance. Other factors, such as stock selection and market timing, are relatively unimportant.

How does an investor decide what percentage of her investment funds to allocate to stocks and bonds, respectively? Historically, the stock market has provided greater average returns than all other asset classes. However, stock market returns can be volatile from year-to-year. Bond prices tend to fluctuate less than stocks. Therefore, many investors put a portion of their portfolio in bonds to reduce overall volatility (or risk). In general, risk-tolerant investors with a long time horizon should keep most of their portfolio in stocks, while risk-averse investors with shorter time horizons should allocate a substantial portion of their investment funds to bonds.

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