Understanding the value of asset allocation

When done well, cooking is the process of combining ingredients to make a dish that’s greater than the sum of its parts. For example, cheese, tomato sauce, and bread all taste fine on their own. But when you combine them to create a pizza, you’ve got something much more satisfying and tasty. Similarly, asset allocation is the process of combining different asset classes to create a total portfolio that best matches your financial goals.

How does the asset allocation process work?

Different asset classes have unique characteristics. For example, this chart shows that over the past 15 years, stocks have returned 10% on an annualized basis (that is, over the course of a year) but with a high level of risk (as measured by the statistical term “standard deviation,” a common measure that investors use for risk). Bonds, on the other hand, have returned only 3.6%, but with much lower levels of risk.

Source: Clearnomics

Investors can take advantage of these different characteristics by combining them in a portfolio. Combining the two asset classes can significantly lower a portfolio's volatility (unpredictability/risk) while still achieving an attractive gain. For instance, an asset allocation of 60% stocks and 40% bonds would have returned 7.5%, more than double the return of bonds, but with a standard deviation of only 10.7%, much less than the risk of stocks alone.

Combining the right asset classes for your goals is like pairing savory and sweet ingredients to get the perfect balance of flavors for your taste. Bon appetit!

Annualized returns: To “annualize” is to convert a short-term rate into an annual rate. Consider an investment that returns 1% a month. Because a year consists of 12 months, the investments will return 12% on an “annualized basis.”

Standard deviation: Standard deviation is a common indicator of market volatility and risk. It aims to reflect how far investment prices stray from their average. When prices stray far from average, this indicates higher standard deviation (or higher volatility/risk). When prices stick closer to their average, this indicates lower standard deviation (or lower volatility/risk).

Volatility: High volatility means the market is changing quickly and unpredictably -- with big swings in stock prices. When volatility is low, on the other hand, prices move in a steady, more predictable manner. We all have that one volatile “friend” who lashes out when we least expect it, right? It’s sort of the same thing.