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The Three Main Asset Classes
Stocks: Ownership stakes in companies
- Expected return: 9-10% annually
- Volatility: 15-18% annually
- Best for: Long-term growth
- Worst case: -40% to -50% in severe recessions
Bonds: Loans to governments and corporations
- Expected return: 4-5% annually
- Volatility: 4-6% annually
- Best for: Stability and income
- Worst case: -10% to -15% in severe sell-offs
- Benefit: Negatively correlated with stocks (bonds rise when stocks crash)
Cash: Money in banks or money market funds
- Expected return: 4-5% annually (currently)
- Volatility: 0% (guaranteed)
- Best for: Immediate needs, emergency reserves
- Worst case: Zero (you won't lose money, but inflation erodes purchasing power)
Asset Allocation Determines Returns
Research shows asset allocation explains 90-95% of portfolio return variance. Individual security selection and market timing are far less important.
Example: Three portfolios with different allocations, all owning S&P 500 stocks
Portfolio A (80% stocks, 20% bonds):
- Annual return: 8.4%
- Annual volatility: 12.5%
Portfolio B (60% stocks, 40% bonds):
- Annual return: 7.2%
- Annual volatility: 9%
Portfolio C (40% stocks, 60% bonds):
- Annual return: 6%
- Annual volatility: 6.5%
All three own identical stocks. The allocation determines expected return and volatility. Security selection (which specific stocks) is minor.
Allocation by Goals and Time Horizon
Goal: Retirement in 40 years
- Time horizon: 40 years (can endure volatility)
- Risk tolerance: High
- Allocation: 90% stocks, 10% bonds
- Expected return: 9.5%
Goal: Home down payment in 3 years
- Time horizon: 3 years (cannot endure large losses)
- Risk tolerance: Low
- Allocation: 20% stocks, 60% bonds, 20% cash
- Expected return: 4%
Goal: Retirement in 5 years
- Time horizon: 5 years (somewhat limited)
- Risk tolerance: Moderate-low
- Allocation: 40% stocks, 50% bonds, 10% cash
- Expected return: 5.5%
Goal: Retiree withdrawing funds
- Time horizon: 25-30 years (longer than most think, but volatility is painful)
- Risk tolerance: Moderate
- Allocation: 50% stocks, 45% bonds, 5% cash
- Expected return: 6.5%
Allocation and Volatility
Allocation directly controls portfolio volatility:
100% stocks: ±18% annual volatility (best year: +50%, worst year: -40%) 70/30 portfolio: ±11% annual volatility (best year: +30%, worst year: -25%) 50/50 portfolio: ±8% annual volatility (best year: +20%, worst year: -15%) 30/70 portfolio: ±5% annual volatility (best year: +12%, worst year: -8%) 100% bonds: ±4% annual volatility (best year: +8%, worst year: -5%)
More stocks = higher expected return, higher volatility. Choose the allocation matching your risk tolerance.
Correlation: Why Diversification Works
Different assets move differently. This is crucial:
Stocks and bonds correlation: -0.2 (negative, they move opposite)
- When stocks crash, bonds often rise (investors flee to safety)
- A 70/30 portfolio is more stable than 100% stocks
Stocks and cash correlation: 0 (unrelated)
- Cash is stable; stocks are volatile
- Adding cash reduces portfolio volatility
U.S. stocks and international stocks correlation: 0.7 (positive, similar but not identical)
- They move together but not perfectly
- Adding international stocks provides some diversification benefit
Sample Allocations
Simple three-fund portfolio:
- 50% U.S. total market (VTI)
- 30% International stocks (VXUS)
- 20% Bonds (BND)
- Expected return: 7.5%
- Expected volatility: 10%
Bogle's three-fund portfolio:
- 33% U.S. stocks (VTI)
- 33% International stocks (VXUS)
- 33% Bonds (BND)
- Expected return: 7%
- Expected volatility: 9%
All-in-one target-date fund:
- Single fund automatically adjusts allocation based on years to retirement
- Example: Vanguard Target Retirement 2050 (for age 25)
- Currently: 85% stocks, 15% bonds
- Automatically becomes more conservative each year
- Expected return: 8.5%
- Expected volatility: 12%
Rebalancing
Allocation drifts as assets grow at different rates. Rebalancing returns to target:
Original allocation: 70% stocks, 30% bonds
After 5 years (stocks up 50%, bonds up 10%):
- Stocks: Now 78% of portfolio
- Bonds: Now 22% of portfolio
Rebalancing: Sell some stocks ($50,000), buy bonds ($50,000)
New allocation: 70% stocks, 30% bonds (back to target)
Benefits:
- Maintains target risk
- Forces you to sell winners (stocks) and buy losers (bonds)—contrarian discipline
- Historically improves returns by 0.1-0.2% annually
Rebalancing Frequency
Quarterly rebalancing: Too frequent; wastes money on transaction costs
Annual rebalancing: Optimal balance between maintaining allocation and minimizing costs
Rebalancing threshold: Only rebalance if allocation drifts >5% from target (reduces unnecessary trading)
The Bottom Line
Asset allocation is the foundation of portfolio returns. Choose an allocation matching your time horizon and risk tolerance. Maintain it through regular rebalancing. The specific stocks or bonds matter far less than the overall allocation.
A simple allocation (70/20/10 stocks/bonds/cash) beats complex strategies 90% of the time. Simplicity, consistency, and discipline matter more than complexity.
The case for simple and low-cost
John C. Bogle argued that a simple, low-cost allocation beats most active strategies over time — the founding idea behind Vanguard and the index fund.
