Asset allocation: stocks, bonds, and time
Key takeaways
04 · ideas- Younger investors: tolerate 90–100% stocks
- Bonds reduce volatility but lower long-term returns
- Rebalance annually to maintain target allocation
- Target-date funds do this automatically
Basic level
The essentials · 1 min
Asset allocation is how you split your investments between stocks (higher return, higher risk) and bonds (lower return, lower risk).
The classic rule: 110 minus your age = stock percentage- Age 30 → 80% stocks, 20% bonds
- Age 50 → 60% stocks, 40% bonds
- Age 70 → 40% stocks, 60% bonds
Why this matters: In 2008, stocks dropped 37%. A 100% stock portfolio lost $370,000 on every $1M. A 60/40 portfolio lost about $200,000. The difference: lower returns in good years, much less pain in bad years.
Intermediate level
How it applies · 1 min
The risk-return tradeoff
| Allocation | Expected annual return | Worst single year (historical) | Recovery time |
|---|---|---|---|
| 100% stocks | ~10% nominal | -43% (1931) | 3–5 years |
| 80/20 | ~8.5% | -34% | 2–4 years |
| 60/40 | ~7.5% | -26% | 2–3 years |
| 40/60 | ~6% | -18% | 1–2 years |
| 100% bonds | ~4% | -8% | <1 year |
The 110-minus-age rule has evolved: Many advisors now use 120 or 130 minus age because people live longer and low bond yields have reduced the protection bonds offer. A 30-year-old might reasonably hold 90–100% stocks.
Rebalancing: If stocks outperform, your allocation drifts (e.g., 60/40 becomes 70/30). Annual rebalancing — selling winners, buying underperformers — maintains your target. Studies show rebalancing adds ~0.5% annual return through forced "buy low, sell high."
Advanced level
The math, step by step · 2 min
Modern Portfolio Theory: efficient frontiers
Harry Markowitz's 1952 insight: diversification can reduce risk without proportionally reducing return. Two imperfectly correlated assets create a portfolio with better risk-adjusted returns than either alone.
Correlation matters:- US stocks and US bonds: correlation ~-0.1 to -0.3 (negative = diversification benefit)
- US stocks and international stocks: correlation ~0.7 (moderate — still some diversification)
- US stocks and REITs: correlation ~0.6
Sharpe Ratio — return per unit of risk:
Where R_p is portfolio return, R_f is risk-free rate, \sigma_p is portfolio standard deviation. Higher = better risk-adjusted performance.
Historical Sharpe ratios:- 100% US stocks: ~0.45
- 60/40 portfolio: ~0.52
- Optimal diversified (global stocks + bonds): ~0.58
The 60/40 paradox: lower returns than 100% stocks, but better Sharpe ratio — you get more return per unit of risk accepted.