Asset allocation: the biggest portfolio decision

How you split money between stocks, bonds and cash shapes the ride more than which individual fund you pick.

Asset allocation Asset class Stocks Bonds Cash equivalents

Allocation vs diversification

The Diversification lesson covered spreading money within an asset class so no single company can sink you. Asset allocation is the level above: how much goes into different asset classes — mainly stocks, bonds and cash — which tend to respond differently to the same events.

Diversification reduces company-specific risk. Allocation sets how much market-wide risk you accept in the first place.

What each class usually does

Stocks: ownership in businesses. Historically higher long-run growth, with deep and sometimes long declines. Bonds: loans to governments or companies. Usually smaller swings, paid through interest, but they can lose value (see the bonds lesson). Cash equivalents: savings and money-market type holdings. Stable in dollar terms, but can lose purchasing power to inflation.

"Usually" matters. There have been periods when stocks and bonds fell together. Allocation reduces the range of outcomes; it does not remove losses.

The blended-return formula

A portfolio's return for a period is the weighted average of its parts: (weight₁ × return₁) + (weight₂ × return₂) + …. This lets you stress-test an allocation before you own it: 'If stocks fell 30%, what would my whole portfolio do?'

Pick an allocation you could hold through a bad year. The best-looking mix on paper is useless if you abandon it at the bottom.

Worked example

Stress-testing a 70/30 mix (hypothetical returns)

Portfolio: $20,000 → $14,000 stocks (70%), $6,000 bonds (30%).
Hypothetical bad year: stocks −30%, bonds +2%.
Stocks: $14,000 × 0.70 = $9,800. Bonds: $6,000 × 1.02 = $6,120. Total $15,920.
Portfolio return = $15,920 ÷ $20,000 − 1 = −20.4%. Check: 0.7 × (−30%) + 0.3 × (+2%) = −21% + 0.6% = −20.4%.
Same year at 100% stocks: −30%, or $14,000 left.

The 70/30 mix still lost money, but $1,920 less than all-stocks in this made-up year. Ask: could I stay invested through −20%?

Common misconceptions

“Owning 10 different stock funds means my allocation is diversified.”

Ten stock funds is still close to 100% stocks. Allocation is about asset classes, not the number of funds.

“Bonds always rise when stocks fall.”

Often they move differently, but not always. Both can fall in the same year.

Checkpoint