What Is Asset Allocation? How to Balance Risk, Return, and Time Horizon

What is asset allocation? Quick answer

Asset allocation refers to dividing a portfolio among equities, bonds, and cash. The appropriate mix depends on investment goals, time horizon, and risk tolerance. For many Canadians, a registered account such as a Tax-Free Savings Account (opens in a new tab) (TFSA) or Registered Retirement Savings Plan (opens in a new tab) (RRSP) holding a low-cost asset allocation ETF may provide a straightforward starting point.

The main asset classes

Understanding the meaning of asset allocation begins with understanding the primary building blocks of an investment portfolio. These building blocks are commonly known as asset classes in investing.

Equities

Equities represent ownership shares in publicly traded companies. Their value may increase or decrease based on company performance, economic conditions, and market sentiment. Compared with other asset classes, equities have generally offered higher long-term growth potential, although they may also experience greater short-term volatility.

Fixed income

Fixed income investing includes securities such as government bonds, corporate bonds, and bond funds. These investments typically involve lending money to a government or company in exchange for interest payments. Bond prices may fluctuate, but fixed income investments have often experienced lower volatility than equities.

When discussing equities vs bonds in Canada, investors are typically comparing the potential for growth with the potential for income and stability.

Cash and cash equivalents

Cash and cash equivalents include products such as high-interest savings accounts, guaranteed investment certificates (GICs), and money market funds. These investments generally have lower levels of price volatility but may also produce lower long-term returns than equities or bonds.

Alternative investments

Some portfolios also include alternative assets such as real estate investment trusts (REITs), infrastructure investments, commodities, or private assets. These investments may add another layer of diversification, although they are often more common in larger or more complex portfolios.

Why different asset classes matter

One reason portfolio asset allocation plays an important role is that different asset classes do not always move in the same direction at the same time. During some market environments, equities may decline while bonds remain relatively stable or increase in value. Holding multiple asset classes may help reduce the overall fluctuations of a diversified portfolio.

What determines an investor’s asset allocation?

Several factors may influence how to allocate investments within a portfolio. Rather than relying on a single formula, many investors consider multiple aspects of their financial situation.

Investment goals

Financial objectives often influence the level of investment risk someone is prepared to accept. Saving for a home purchase within a few years may result in a different asset mix than saving for retirement several decades away.

Time horizon

Time horizon refers to how long money may remain invested before it is needed. Longer investment periods may allow investors to experience short-term market declines while remaining invested for future recovery. Shorter time horizons may place greater emphasis on preserving capital.

Risk tolerance

Risk tolerance investing refers to an individual's comfort with fluctuations in portfolio value. Some investors remain comfortable during periods of market volatility, while others may find temporary losses difficult to accept. Emotional responses to market movements can influence investment decisions as much as financial considerations.

Risk capacity

Risk tolerance differs from risk capacity. Risk capacity refers to the financial ability to absorb investment losses without affecting future financial goals. An investor may feel comfortable accepting risk while still having limited financial capacity to experience significant declines.

Account type

The type of account holding investments may also influence asset allocation decisions in Canada. Tax treatment differs between TFSAs, RRSPs, and non-registered investment accounts, which may affect where certain asset classes are held.

Common asset allocation models

Although every investor's circumstances differ, several portfolio models are commonly used to illustrate different levels of investment risk.

Conservative portfolio

A conservative allocation may hold approximately 30% equities and 70% fixed income investments. This type of balanced portfolio in Canada model generally places greater emphasis on reducing volatility and preserving capital than on maximizing growth potential.

Balanced portfolio

A balanced allocation commonly consists of approximately 60% equities and 40% fixed income, often referred to as the 60/40 portfolio model. This allocation combines exposure to long-term growth through equities while maintaining a meaningful allocation to bonds that may help moderate portfolio fluctuations.

Growth portfolio

Growth portfolios often allocate around 80% to equities and 20% to fixed income. Greater exposure to stocks may increase long-term growth potential, although short-term volatility may also be higher than in balanced portfolios.

All-equity portfolio

An all-equity portfolio typically invests entirely in stocks. This allocation offers the greatest exposure to equity market performance but may also experience the largest declines during periods of market volatility. Longer investment horizons and a higher tolerance for market fluctuations are often associated with this type of allocation.

These examples illustrate common approaches to asset allocation in Canada, but they represent broad models rather than fixed rules. Portfolio allocations may evolve over time as financial goals, investment timelines, or personal circumstances change.

Asset allocation and age: The rule of 110

Some investors use a simple guideline known as the rule of 110 investing when thinking about asset allocation. The guideline involves subtracting an investor's age from 110. The resulting number represents the approximate percentage of the portfolio that could be invested in equities, with the remainder allocated to fixed income or cash.

For example:

• A 35-year-old: 110 minus 35 equals approximately 75% in equities.

• A 65-year-old: 110 minus 65 equals approximately 45% in equities.

The rule of 110 serves as a general reference point rather than a formula. Individual circumstances may differ based on retirement income sources, expected investment timeline, financial goals, and risk tolerance investing considerations.

Life expectancy, pension income, and personal financial circumstances may also influence how someone approaches asset allocation in Canada. For that reason, the rule may provide a starting point for discussion rather than a fixed allocation.

Asset allocation in Canadian registered accounts

Asset location refers to deciding which account type (such as registered or non-registered) is used to hold a particular investment, often based on the tax treatment of that account. This differs from asset allocation, which refers to deciding how much of a portfolio to invest in each asset class. Asset allocation addresses "what to hold"; asset location addresses "where to hold it.

RRSP asset allocation

RRSP asset allocation may include Canadian equities, global equities, and fixed income investments. U.S. dividend-paying stocks held directly inside an RRSP may benefit from the Canada-U.S. tax treaty, which may reduce withholding tax on eligible dividends.

Many investors also hold bond investments in RRSPs because interest income grows on a tax-deferred basis until withdrawal.

TFSA asset allocation

TFSA asset allocation may include many of the same investments as an RRSP. Canadian dividend-paying stocks, exchange-traded funds, and growth-oriented investments may all be held within a TFSA.

Unlike an RRSP, U.S. dividend-paying securities held inside a TFSA may still be subject to U.S. withholding tax on dividends. However, investment growth and eligible withdrawals from the TFSA generally remain tax-free under Canadian tax rules.

Non-registered accounts

In taxable investment accounts, Canadian dividend-paying stocks may qualify for the dividend tax credit, while capital gains receive different tax treatment than interest income. Because tax treatment varies across investment types, asset location Canada may influence after-tax investment outcomes.

All-in-one asset allocation ETFs in Canada

For many investors learning investing basics in Canada, an all-in-one ETF Canada may offer a simple way to build a diversified portfolio.

An asset allocation ETF combines Canadian equities, U.S. equities, international equities, and fixed income investments into a single fund. The fund manager maintains the target allocation and automatically rebalances the portfolio as markets change.

Comparing an all-equity ETF to an 80/20 growth ETF: both funds provide globally diversified equity exposure, but the 80/20 growth ETF also includes approximately 20% fixed income, while the all-equity ETF invests entirely in equities. As a result, the funds may experience different levels of market volatility.

Similarly, investors comparing a growth ETF Canada with a balanced fund are generally evaluating different levels of equity exposure rather than different investment philosophies.

How to rebalance a portfolio

Over time, market movements may cause a portfolio's allocation to drift away from its original target. Rebalancing a portfolio in Canada refers to restoring the portfolio to its intended asset allocation.

For example, a 60/40 portfolio in Canada may gradually become a 70/30 portfolio if equities appreciate more quickly than bonds. Rebalancing returns the portfolio to its target allocation.

Two common approaches include:

• Calendar rebalancing: reviewing the portfolio on a regular schedule, such as annually or semi-annually.

• Threshold rebalancing: making adjustments when an asset class moves beyond a predetermined percentage from the target allocation, such as 5%.

Many asset allocation ETF products perform rebalancing automatically. Investors building portfolios with individual ETFs or securities generally complete the rebalancing process themselves.

Rebalancing may help maintain a consistent risk profile over time as market conditions change.

Common asset allocation mistakes

Asset allocation may evolve throughout an investor's lifetime, but several common issues can affect portfolio construction.

Home bias

Many Canadian investors hold a large percentage of their equity investments in Canadian companies. While Canadian stocks may play an important role in a diversified portfolio, Canada represents a relatively small portion of the global equity market. Portfolio diversification in Canada may include exposure to companies in multiple countries and regions.

Not rebalancing

Without periodic review, market performance may gradually shift a portfolio away from its intended allocation. This may increase or decrease overall portfolio risk compared with the original design.

Confusing risk tolerance and risk capacity

An investor may feel comfortable accepting investment risk while having limited financial capacity to experience significant losses. These two concepts describe different aspects of portfolio construction and may not always align.

Changing asset allocation during market volatility

Short-term market movements sometimes lead investors to make significant allocation changes. Such adjustments may alter the long-term risk profile of a portfolio and may not reflect the investor's original financial objectives.

Overlooking account type

Holding investments without considering asset location Canada may reduce tax efficiency compared with placing different asset classes in different account types.

Conclusion: Asset allocation in Canada

Asset allocation provides the foundation for portfolio construction by determining how investments are divided among equities, fixed income, and cash. Understanding asset allocation may help investors evaluate how different asset classes work together to balance growth potential and investment risk. For many Canadians, a diversified portfolio held in a registered account and built with an all-in-one ETF Canada or another asset allocation ETF may offer a straightforward approach to portfolio management. As financial goals, timelines, or personal circumstances change, the portfolio allocation may also change over time.