How to set your target asset allocation

Asset allocation, how you divide your portfolio across stocks, bonds, and other asset classes, explains more of your long-term investment outcome than any individual security selection decision. Getting it right for your situation is more important than picking the right funds.

Most people either don't have an explicit target allocation, or they copy one from a rule of thumb without understanding the reasoning. Here's how to actually set one.

Start with time horizon

The primary driver of how much equity exposure you should have is how long before you need the money.

Equities generate higher expected returns than bonds over long periods. They also experience larger short-term drawdowns. If you have 30 years before you need your retirement savings, a temporary 40% drawdown is recoverable, painful to watch, but not a problem if you don't need to sell.

If you're 5 years from retirement, a 40% drawdown in year 1 could materially impair your retirement income even if markets recover, because you'd be selling at the bottom to fund living expenses (this is the sequence-of-returns risk).

A rough framework:

• 30+ years to goal: 90-100% equity is defensible
• 20-30 years: 80-90% equity
• 10-20 years: 70-80% equity
• 5-10 years: 60-70% equity
• Under 5 years: 40-60% equity, depending on how fixed your spending needs are

These are starting points, not rules.

Adjust for risk tolerance

Time horizon tells you what you should be able to handle. Risk tolerance tells you what you'll actually do when your portfolio drops 30% in three months.

Theoretical risk tolerance, what you tell yourself on a questionnaire, is often higher than real risk tolerance. Many investors discovered in March 2020 (and again in 2022) that their actual behavior at maximum portfolio drawdown was different from what they'd predicted.

A useful test: imagine your $500,000 portfolio drops to $350,000 in six months. Do you: A. Rebalance into equities because they're on sale B. Hold your current allocation and wait C. Move to more conservative allocation to stop the bleeding D. Sell everything

If your honest answer is C or D, your equity allocation should be lower than your time horizon alone would suggest.

Real risk tolerance is revealed by behavior under stress, not by questionnaire responses in calm markets.

Within equities, determine geographic allocation

Once you've set your equity percentage, decide how much goes to U.S. vs. international.

U.S. stocks are roughly 60% of global market capitalization. A market-cap-weighted allocation to global equities would be roughly 60% U.S., 40% international. In practice, most U.S. investors hold 70-100% domestic equities (home country bias is well-documented globally).

The academic case for international diversification is solid. U.S. and international returns have different cycles. Holding some international exposure reduces the risk that U.S. market underperformance relative to global markets drives your outcome.

A common starting point for U.S. investors: 70% U.S. / 30% international within the equity sleeve.

Within bonds, determine duration and credit quality

The bond portion of your portfolio serves two purposes: dampening volatility and (for shorter durations) providing liquidity.

Duration: Short-duration bonds (1-5 years) are less sensitive to interest rate changes. Long-duration bonds (10+ years) provide more dramatic negative correlation to equities in a crisis but fall harder when rates rise. Intermediate duration (5-7 years) is a reasonable default.

Credit quality: Investment-grade (BBB and above) bonds are less correlated to equities than high-yield bonds. If your bond allocation is primarily serving a defensive role, stay investment-grade or above.

Review, don't optimize constantly

Set your target allocation and write it down. Rebalance when you drift more than 5 percentage points from target. Review the underlying logic of the target when your life situation changes significantly: major income change, new financial goal, approaching retirement, inheriting assets.

Don't change your target allocation because of market conditions. The whole point of having a target is that it doesn't change based on what the market did last month.

How Prismfolio helps

Prismfolio shows your current allocation against your stated target, with drift highlighted. It doesn't tell you what your target should be, that's a decision that depends on your specific situation. It does make it trivial to see whether you're within your intended range and when a rebalance is due.

The target is only useful if you can see when you've drifted from it.