The Basics: Your Asset Allocation


Figuring out your asset allocation can be intimidating to many, but it is essential when it comes to minimizing your risk. Once you are ready to begin investing and have figured out your risk tolerance, you should then figure out what annual return you are happy with and it should be apart of your plan. (Remember to get a handle on your debts, budget and have a good emergency fund before you begin investing. See Part 1 about your risk tolerance if you haven’t already).

Assigning a target annual rate of return for your long-term goals is essential, and not just having the idea of “I need to get the most I can get.” To put this in perspective, see what the following annual returns looked like over the last 5 calendar years for a variety of asset classes (or a group of securities with similar characteristics).

ETF (exchange-traded fund) Net Asset Values are used to calculate the return. Return results are provided by Morningstar. KIT Today has reviewed the data but does not guarantee its correctness. Please see for more information on how rates of return are calculated. Because you cannot invest an index, ETFs are used in the example. Their returns are shown after fund expenses but do not include any fees associated with a financial consultant or trading costs with the custodian. Additional fees can reduce your annual rate of return another 1% to 2%. Keep your eye out for future posts that cover fees in detail and how they impact your portfolio, and how to minimize them.


There are many asset classes you can include in your portfolio, and combining them in the right way can help minimize risk for a given return target.The examples shown above in the graph are described below, but certainly there are more you can add as your knowledge and account values grow. 

·        The S&P 500 is a broad group of US stocks covering a variety of industries and company sizes. This basket of stocks is commonly used as an index to measure market performance and volatility for US stocks. (SPY is an ETF that mimics this index)

·        The MSCI EAFE (Morgan Stanley Capital International – Europe Australasia and Far East) is a broad group of foreign stocks that cover a variety of industries and company sizes. These stocks come from developed countries; such as the UK, Japan, Switzerland or Australia. This basket of stocks is commonly used as an index to measure the performance and volatility of foreign stocks. (EFA is an ETF that mimics this index)

·        Bloomberg Barclays US Aggregate Bond Index is a broad group of US bonds that range in type, risk and income. This basket of bonds is commonly used as an index to measure the performance and volatility of US bonds. (AGG is an ETF that mimics this index)

·        MSCI US REIT Index is a broad group of equities that are Real Estate Investment Trusts generating income and returns from investments in real estate properties of all types. This basket of REITs is used as an index to measure the performance and volatility of US REITs. (VNQ is an ETF that mimics this index)

 In the graph, you can see there is a wide range of returns that can happen over the years. By spreading your money out across many asset classes you can cause your total return to be more steady, with less fluctuation or volatility, year after year. By learning more about different asset classes you can determine which ones work best together to offset potentially negative periods of return.

One of the most popular methods of deciding how to mix asset classes and assigning a percentage to them is by utilizing the Modern Portfolio Theory (MPT) and the Efficient Frontier, created by Nobel Prize winner Harry Markowitz. The theory uses historical and/or expected risk and return results for each asset class. It also uses a measurement for how much each asset class moves together with different market environments, also known as correlation. The below graphic shows the result of the Modern Portfolio Theory, the Efficient Frontier. The line is the Efficient Frontier, and it is made of different portfolios with different asset allocations to a variety of asset classes. The line of portfolios is considered the optimal result for a given level of risk.

There are limitations to this theory when it comes to using real world scenarios, but it is widely used among analysts to guide them to creating asset allocations for their clients; and you can read more about it here. As described on Wikipedia, the theory uses complex formulas and calculations and you would need the help of a financial consultant or online tool (which may be available through your account custodian; like TD Ameritrade, Schwab or Fidelity) to generate an optimal asset allocation using this method. Watch for an upcoming post to review different tools you can use when creating your portfolio. Let’s focus on the knowledge and understanding components first.

If you are just starting with your savings plan you may not be able to buy investments in all asset classes. Start with broader asset class investments (you can purchase single mutual funds that will invest across a variety of asset classes with a small reoccurring savings amount). As your savings grow begin adding asset classes. I like to invest a minimum of 5% in any one asset class (many investments have a minimum initial investment you have to meet). Part 3 of this Basics series will cover implementing the asset allocation and how to choose what to buy for your account or accounts. Part 4 will cover how to monitor your investment choices and your asset allocation going forward (can’t forget about rebalancing as your investments change in value). Keep learning, knowledge is key!


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