Asset Allocation
Before you pick a single stock, the single decision that will affect your returns the most is a boring-sounding one: how you split your money between broad categories of assets in the first place.
The strategic split between stocks, bonds, cash, and alternatives
Once you accept that diversification matters, the next question is: diversified across what? The highest-level answer is asset allocation — the decision of how to divide your total investment money among broad categories of assets, before you even choose individual holdings within each category. The main categories are:
| Asset class | Typical role | Typical behaviour |
|---|---|---|
| Stocks (equities) | Growth engine | Higher expected return, higher volatility |
| Bonds (fixed income) | Stability and income | Lower expected return, lower volatility, regular interest payments |
| Cash / money market | Safety and flexibility | Very low return, near-zero volatility, instantly accessible |
| Alternatives (REITs, commodities, private assets) | Diversification beyond stocks/bonds | Varies widely; often lower correlation to stocks |
Research on institutional portfolios has repeatedly found that this top-level split — not the specific stocks you pick within your equity allocation — explains the large majority of the differences in long-run portfolio returns and risk between investors. Picking good individual stocks matters, but deciding "I will hold 70% stocks and 30% bonds" matters more.
Age-based allocation: why young investors can take more risk
A common piece of advice is that younger investors should hold a higher percentage of stocks than older investors. The reasoning rests on one resource that shrinks with age: time horizon — the length of time before you'll need to spend the money you've invested.
If you're 17 and investing for retirement at 65, you have roughly 48 years for the market to recover from any crash. Stock markets have historically fallen sharply many times — 2000, 2008, 2020 — but have also recovered and gone on to new highs every single time, given enough years. A young investor can ride out a 2008-style 50% crash because they won't need that money for decades; a 64-year-old about to retire cannot, because they may need to start withdrawing money in months, with no time to wait for a recovery. This is why a common (though rough) rule of thumb is "own a percentage of stocks equal to 100 minus your age" — meaning a 20-year-old might hold 80% stocks, while a 60-year-old holds 40%. Real financial planning is more nuanced than one formula, but the underlying logic — take more risk when you have more time to recover from it — is sound and worth internalizing early.
Rebalancing: what it is and why you need to do it
Once you've picked a target allocation, markets won't respect it. If stocks rally hard, your "70% stocks" portfolio might drift to 80% stocks purely because stock prices rose faster than bond prices — you didn't do anything, but your risk level quietly increased. Rebalancing is the practice of periodically buying and selling assets to bring your portfolio back to its original target allocation.
Concretely: if your target is 70% stocks / 30% bonds and drift pushes you to 80%/20%, you would sell enough stocks and buy enough bonds to bring the split back to 70/30. This does two useful things at once. First, it keeps your risk level consistent with what you originally decided was appropriate for your goals — you don't end up more exposed to a stock crash than you intended, just because stocks happened to do well recently. Second, it mechanically enforces a "sell high, buy low" discipline: you're trimming the asset class that has become expensive relative to your target, and adding to the one that's now comparatively cheaper, without needing to predict which one will do better next. Most investors rebalance on a schedule (e.g., once a year) or when an allocation drifts more than a set amount (e.g., 5 percentage points) from its target.
The 60/40 portfolio: what it is and whether it still works
The most famous asset allocation "recipe" in investing history is the 60/40 portfolio — 60% stocks, 40% bonds. The logic: stocks provide long-run growth, bonds provide ballast, since bonds have historically tended to hold up or even rise when stocks fall sharply (investors flee to the relative safety of government bonds during a stock market panic), giving the portfolio a smoother overall ride than an all-stock portfolio.
Whether it "still works" is genuinely debated. In 2022, both stocks and bonds fell together — a rare event, driven by rapidly rising interest rates that hurt bond prices at the same time inflation fears hurt stock prices — which briefly broke the "bonds go up when stocks go down" assumption the whole strategy relies on. Critics argue that with interest rates having been near zero for over a decade, bonds' cushioning power and expected returns are structurally lower than in the 1980s-2000s, when the 60/40 approach built its reputation. Supporters counter that 2022 was an unusual year, that bond yields are now higher (making bonds' expected future returns more attractive again), and that no simple alternative has proven reliably better over the long run. The practical takeaway for a young investor: 60/40 is a reasonable, well-tested reference point — not a rule you must follow, but a useful starting point to adjust based on your own age, goals, and risk tolerance, informed by the age-based logic above.
If your target allocation is 70% equities, 30% bonds, and equities rise strongly to become 85% of your portfolio, what should you do?
Reveal Answer
Rebalance: sell enough equities and buy enough bonds to bring the portfolio back toward 70% equities / 30% bonds. Even though equities have performed well, letting the allocation drift to 85% equities means your portfolio is now carrying more risk than you originally decided was appropriate — if a downturn hits, you'd be far more exposed than intended. Rebalancing here also has the practical effect of "selling high": you're trimming the asset class (equities) that has just become expensive relative to your target, and adding to the one (bonds) that is now comparatively cheaper — a disciplined process that doesn't require predicting what markets will do next. This is typically done either on a set schedule (e.g., annually) or when the drift exceeds a set threshold (e.g., more than 5-10 percentage points off target), which an 85% vs 70% target (a 15-point drift) would clearly trigger.