This post contains affiliate links. If you purchase an item at these links we may earn a commission. See more here.
When setting up a investment portfolio, it’s important to decide how you’re going to allocate the funds across different assets classes. Now determining what the best asset allocation for you depends a lot on your goals and risk appetite. That said, there are some good principles you can use at any stage to figure out the best allocation for you. Let’s dig into it.
Asset Allocation Classes
There are a lot of different potential asset classes, and building wealth can be done with a variety of assets. As this article is focusing on an investment portfolio, we’re going to focus on two: Equities (e.g. stocks), and Fixed Income (e.g. Bonds).
Stocks
Equities or stocks represent purchasing shares of a company. By purchasing a stock, you are purchasing a (typically miniscule) portion of the issuing organization. For example, if you purchased a share of Apple, you would own one of almost 16 billion shares outstanding. Under stocks, there are also ways to further sub-categorize:
Stocks Sub-Categories
Here is a listing of securities sub-categories, ranked from lowest risk to highest risk.
| Sub-Category | Description: |
| Large-Cap | Shares of companies with a market capitalization (total value of outstanding shares) of more than $10 billion. These are large, established companies who have a record of success. |
| Mid-Cap | Shares of companies with a market capitalization of between $2 billion and $10 Billion. |
| Small-Cap | Shares of companies with a market capitalization of less than $2 billion. These companies are typically higher risk due to their small size and lower liquidity. Meaning that a small volume of trading can have outsized effects on the stock price. |
| International Securities | Stocks issued by a foreign company and listed on a foreign exchange. These stocks are affected by changes in currency conversion rates, making them higher risk. |
| Emerging Markets | Stocks issued by companies in developing nations. These stocks can potentially have high returns as there is typically a lot of opportunity in emerging nations, but are also high risk due to the tumultuous business environment. |
Bonds
Fixed income or bonds represent an investment that pays a fixed income. Basically, by purchasing bonds, you are lending money to an entity. The entity will pay you a fixed interest rate until the bond maturity date, at which point the full amount you initially invested will be returned to you.
There are two common classes of bonds (i.e. two entities you’re lending to): Government and Corporate. Government bonds are issued by various levels of the government. The chances of a Canadian or American government failing is miniscule, so they are typically very safe. As a result, they will usually have lower returns. Corporate bonds are issued by corporations. As these corporations have some possibility of going bankrupt, the risk is higher, and thus so is the return.
Generally, bonds are much safer than stocks.
Optimal Asset Allocation Across Bonds vs. Stocks
When thinking about stocks vs. bonds, often the real question you’re asking is how much risk do you want to have in your investment portfolio? The answer to that question depends on the individual and what their investment goals are. If you’re investing money that you’d like to use in 5 years, putting a large percentage into stocks would not be wise as they could drop and not rebound by the time you need the money.
For this article, we’re going to focus on investing for retirement. As a result, your age is useful in determining what percentage you want in stocks vs. bonds. When you are young, you have a lot of time for your money to grow. You also have a lot of time to recover if the stock market crashes. So though a 30% drop would hurt, if you don’t need the money for another 30 years you have the time to ride it out and let the stocks rebound. On the other hand, as you’re nearing retirement age where you’ll need use of the money, a big drop could have a large effect on your quality of life. Thus, more stability in the form of bonds is desired.
Rule of 100/110/120
Historically, the rule of thumb has been subtract your age from 100, and keep that percentage in stocks. So if you were 30 years old, you’d have 70% in stocks and 30% in bonds. However, as humans are working and living longer, the rule is often changed to subtracting from 110. Similarly, if you had a higher risk tolerance, you could increase it to 120. Let’s see what that looks like:
| Age | Rule of 100 | Rule of 110 | Rule of 120 |
| 25 | 75% Stocks | 25% Bonds | 85% Stocks | 15% Bonds | 95% Stocks | 5% Bonds |
| 35 | 65% Stocks | 35% Bonds | 75% Stocks | 25% Bonds | 85% Stocks | 15% Bonds |
| 45 | 55% Stocks | 45% Bonds | 65% Stocks | 35% Bonds | 75% Stocks | 25% Bonds |
| 55 | 45% Stocks | 55% Bonds | 55% Stocks | 45% Bonds | 65% Stocks | 35% Bonds |
| 65 | 35% Stocks | 65% Bonds | 45% Stocks | 55% Bonds | 55% Stocks | 45% Bonds |
Take a moment to think where you you fall with regards to risk tolerance. I recommend purchasing a bond index fund to quickly and cheaply diversify.
Allocation Across Stock Sub-Categories
Of the portion of your portfolio dedicated to stocks, you also want to be thoughtful about what subcategories you’re choosing. In my eyes, the best way to be properly diversified is by the use of index funds. These allow you quickly and inexpensively purchase a bundle of stocks, with very little day-to-day maintenance.
Here’s my recommendation of how to allocate the stocks in your account:
- U.S. Large-Cap (S&P 500 Index Fund) – 40-60%
- These companies have a solid track record, and the S&P 500 has averaged a return of ~10% annually since it’s inception in 1957. In fact, Warren Buffet recommends that for most people, a S&P 500 index fund is the best thing to own.
- U.S. Remainder of Market (U.S. Market Index Funds – Excluding S&P 500) – 20-30%
- Owning a whole market index fund allows you to get exposure to small- and mid-cap stocks that are up and coming, enabling potentially higher returns. Just be careful to purchase an index fund that excludes the S&P 500, otherwise you’ll be double counting those stocks.
- International Stocks (International Index Fund) – 20-30%
- As mentioned above, international stocks represent a great opportunity, but also come with more risk. Having some exposure means to can get good returns, but also limits downside in bad times.
If you are wondering what to look for when choosing specific index funds – read more here.
The Best Asset Allocation by Age
Using the average rules and recommendations shared in this article, here is what a good portolio can look like at various ages (rounded for simplicity). Keep in mind that you can adjust this as per your own preferences:
| Age | Bonds | S&P 500 | U.S Whole Market | International Stocks |
| 25 | 15% | 50% | 17.5% | 17.5% |
| 35 | 25% | 45% | 15% | 15% |
| 45 | 35% | 40% | 12.5% | 12.5% |
| 55 | 45% | 35% | 10% | 10% |
| 65 | 55% | 30% | 7.5% | 7.5% |
You also will want to re-allocate and adjust as time passes. This keeps your portfolio in line with your risk tolerance and goals
Summary
Now you know what the possible asset types, and a good starting point for your asset allocation looks like. There’s no perfect asset allocation, and what’s best for you will depend on your personal risk tolerance and goals. That said, don’t fall into analysis paralysis with determining the perfect allocation. Instead, pick an asset allocation that’s in line with your goals, and take action. In the time you spend analyzing you could be missing opportunities.
For more reading on the topic (and Taylor Larimore’s recommendation for asset allocation), check out: