An prudent investment strategy starts with an asset allocation suitable for the portfolio’s objective.
The allocation should be built upon reasonable expectations for risk and returns, and should use diversified investments to avoid exposure to unnecessary risks.
Both asset allocation and diversification are rooted in the idea of balance. Because all investments involve risk, investors must manage the balance between risk and potential reward through the choice of portfolio holdings.
When building a portfolio to meet a specific objective, it is critical to select a combination of assets that offers the best chance for meeting that objective, subject to the investor’s constraints.1 Assuming that the investor uses broadly diversified holdings, the mixture of those assets will determine both the returns and the variability of returns for the aggregate portfolio.
This has been well documented in theory and in practice. For example, in a paper confirming the seminal 1986 study by Brinson, Hood, and Beebower, Wallick et al. (2012) showed that the asset allocation decision was responsible for 88% of a diversified portfolio’s return patterns over time:
Investment outcomes are largely determined by the long-term mixture of assets in a portfolio.
Note: Calculations are based on monthly returns for 518 U.S. balanced funds from January 1962 through December 2011. For details of the methodology, see the Vanguard research paper The Global Case for Strategic Asset Allocation (Wallick et al., 2012).
Many investors use asset allocation as a way to diversify their investments among asset categories. By including asset categories with investment returns that move up and down under different market conditions within a portfolio, an investor can protect against significant losses. Historically, the returns of the three major asset categories have not moved up and down at the same time. Market conditions that cause one asset category to do well often cause another asset category to have average or poor returns. By investing in more than one asset category, you’ll reduce the risk that you’ll lose money and your portfolio’s overall investment returns will have a smoother ride. If one asset category’s investment return falls, you’ll be in a position to counteract your losses in that asset category with better investment returns in another asset category.