Asset Allocation

by Scott Dolson

July 10, 2024

When it comes to your investments, asset allocation is the foundation upon which long-term success is built. So, the first question is—What exactly is asset allocation and why does it matter? 

Asset allocation is the overall makeup of a portfolio at the highest level and is traditionally categorized across two different classes: equity (stocks) and bonds (fixed income).  Over the last decade, a third category, alternatives, has developed to include most investments not in a traditional class. For our purposes, we’ll focus on stocks and bonds because they are the most prevalent, liquid, and well-known internationally. 

Asset allocation matters because this mix of stocks and bonds establishes the risk level and potential return of a portfolio.  Also referred to as risk/return, this dynamic profile ultimately drives long-term performance. Historically, an investment in stocks is riskier than an investment in bonds; therefore, to compensate for the additional risk, we expect a higher return on stocks compared to bonds over time. Although there may be periods when bonds outperform stocks, stocks win over an extended period (years and decades) as shown by the following Annualized Performance for the last 25 years ending December 31, 2023:  

In this example, a cash return was included to show that the risk/return profile of cash is less than that of bonds.  This concept reinforces that investors are compensated for taking on more incremental levels of risk over time.  For the long-term investor, owning risky assets (stocks and bonds) helps to enhance portfolios and increase overall wealth. While some investors prefer to hold cash to preserve their principal and shield themselves from market risk, it guarantees exposure to purchasing power risk due to the long-term effects of inflation. Purchasing power risk is the concept that inflation diminishes the value of a dollar over time. For example, think of the “dollar” store where an item used to sell for $1.00 but now sells for $1.15, this same item now costs 15% more as the price has inflated over time.

As we think about the growth spectrum for risk assets, we expect that stocks should return more than bonds and bonds should return more than cash. The next question is—How much should your portfolio have in stocks and how much in bonds? The answer—It depends. This mix is dependent on each investor’s risk tolerance and time horizon. Given that stocks are riskier, and thus more volatile than bonds, an investor with high risk tolerance can handle a higher allocation to stocks and limited or no allocation to bonds. Conversely, an investor with low-risk tolerance can handle limited or no allocation to stocks and a higher allocation to bonds. An investor with a moderate risk tolerance typically falls somewhere in the middle. Since stocks are the growth engine of the portfolio, when bonds are added, we expect them to act as a diversifier.  Therefore, bonds help to reduce the potentially large value fluctuations within the portfolio. When determining an appropriate asset allocation, our goal is to establish a diversified mix that will participate when stocks go up yet defend or preserve when stocks are struggling.

With a basic understanding of our building blocks, stocks and bonds, the final questions

are—How do we put them together to build an optimal portfolio and how often should asset allocation be reviewed? At Grant Street, we recognize that although stocks will be the growth driver for portfolio assets over time, many investors are uncomfortable with the volatility associated with an allocation to 100% stocks.  For that reason, we create custom and diverse portfolios that allocate across the growth spectrum.  Our objective is to earn the highest risk-adjusted return as possible. Simply put, we aim to earn more return for the amount of risk taken.  It is prudent to review your portfolio annually (at the least) to ensure your allocation aligns with your risk tolerance and your life situation. Evaluating overall asset allocation ensures that your portfolio is in the best possible position to balance risk versus reward and support you in achieving your long-term goals.

If you’d like to discuss your asset allocation or long-term goals with an experienced advisor, please reach out for an introductory discussion to get started: 412-257-8060 or advisors@gsaminc.com.