Asset allocation

Explanation

Your asset allocation is the mix of broad investment types you hold, for example 60% stocks and 40% bonds. Within those, you might further split between US and international stocks, or between short-term and long-term bonds.

Different asset classes behave differently:

• Stocks have historically offered higher long-run returns with large swings, including declines of 50% or more.
• Bonds have usually offered lower returns with smaller swings, and high-quality bonds have often (not always) held up when stocks fell. In 2022, stocks and bonds fell together.
• Cash is stable in nominal terms but has often failed to keep up with inflation after taxes.

The expected return of a portfolio is the weighted average of its parts. Its volatility, however, is usually less than the weighted average, because assets that do not move in lockstep partly offset each other. That is the benefit of diversification.

Choosing an allocation is a trade-off between growth and stability. More stocks raise expected long-run wealth but widen the range of outcomes, including bad ones early in retirement. Many retirees hold a meaningful stock share because their money has to last decades, and very conservative portfolios historically supported lower safe withdrawal rates.

In scenarios, you set an allocation (and can change it over time, such as a glide path). The app derives the expected return and volatility from it, and Monte Carlo runs draw returns for each asset class.

Example

Assume (for illustration) stocks: 7% expected return, 16% volatility; bonds: 4% expected return, 6% volatility; correlation 0.1.

A 60/40 portfolio:

• Expected return: 0.6 × 7% + 0.4 × 4% = 4.2% + 1.6% = 5.8%
• Weighted-average volatility: 0.6 × 16% + 0.4 × 6% = 12.0%
• Actual portfolio volatility, accounting for correlation: about 10.1%

The portfolio captures most of the stock return with noticeably less risk than a weighted average would suggest.