Asset Allocation
Asset allocation explains 91.5% of portfolio performance [@brinson1986]. Not stock picking. Not market timing. Just the mix of stocks, bonds, and other assets.
This is the only decision that matters for most investors.
The Only Free Lunch
In finance, higher returns usually require higher risk. There’s one exception: diversification.
By combining assets that don’t move together (stocks + bonds, US + international), you reduce volatility without reducing expected returns. Free risk reduction. Take it.
The Three-Fund Portfolio
For 99% of investors, this is the answer:
| Fund | Purpose | Example |
|---|---|---|
| Total US Stock Market | Domestic growth | VTI |
| Total International Stock | Global diversification | VXUS |
| Total Bond Market | Stability, income | BND |
Adjust the ratio based on age and risk tolerance. More stocks = more growth + more volatility. More bonds = more stability + less growth.
Simple rule: Bond allocation = your age (30 years old = 30% bonds). Adjust based on risk tolerance.
What Doesn’t Matter
- Which specific stocks to buy (index covers all of them)
- When to buy (time in market beats timing)
- Active fund managers (they lose to indexes)
The decision between 80/20 stocks/bonds vs 70/30 matters. The decision between VTI and VOO barely matters. Focus on what moves the needle.
Definition
Asset allocation is the decision of how to divide your investment portfolio among different asset classes — primarily stocks, bonds, and cash. Research shows this single decision explains 91.5% of portfolio performance variation over time, dwarfing the impact of individual security selection or market timing. The concept is sometimes called “the only free lunch in finance” because diversification across uncorrelated assets can reduce risk without sacrificing expected returns.
When This Applies
- Starting to invest: Your first decision should be allocation (what mix of stocks/bonds), not stock picking
- Approaching a life milestone: Age, risk tolerance changes, or nearing retirement should trigger rebalancing
- Reacting to market volatility: When tempted to sell during a downturn, remember: your allocation already accounts for volatility
- Evaluating investment advice: If someone is selling stock picks or market timing, they’re focused on the 9% that barely matters
Related
- Protocol: Automate Investing (implement your allocation automatically)
- Concept: Compound Interest (allocation determines the rate at which compounding works)
- Concept: Active vs Passive (why index funds are the default for most allocations)
- Anti-Patterns: Wealth Anti-Patterns (stock picking, market timing)
91% of returns come from allocation. Stop obsessing over the other 9%.
See Automated Investing for implementation.