HOHO-ECONOMICUS Insight

1. Introduction: It’s About Structure, Not Stocks

When individual investors first enter the stock market, their most common questions are usually “Which stock looks promising?” or “Is it okay to buy this stock now?” However, these questions are far from the essence of investing. If an investor’s focus remains solely on stock selection, the overall return of their assets inevitably depends on chance. This becomes a major obstacle to long-term wealth accumulation. In reality, the key variable that determines long-term returns is not individual stocks but the allocation ratio among asset classes — that is, the asset allocation strategy. This chapter examines what asset allocation is and why most investment performance derives from it, with a structural and logical approach.

2. Definition and Purpose of Asset Allocation

Asset allocation is the strategic decision-making process of distributing an investor’s assets across different asset classes. An asset class refers to a group of assets with similar risk characteristics and return structures. Traditionally, stocks, bonds, and cash equivalents have been regarded as the main asset classes. Recently, alternative assets such as real estate, commodities, and cryptocurrencies have also been added to the list.

The purpose of asset allocation is not merely to spread risk. The core idea is to ensure portfolio resilience amid market unpredictability and to pursue long-term, stable returns. In other words, the strategy aims not to maximize returns but to minimize losses and design the sustainability of compounding returns.

3. Asset Allocation and the Compounding Structure

The power of compounding refers to how investment returns accumulate exponentially over time. For example, a portfolio with an average annual return of 7% will double in approximately 10 years, quadruple in 20 years, and grow more than eightfold in 30 years. However, this compounding structure is extremely vulnerable to losses.

A single significant loss can destroy the compounding structure. For instance, if a portfolio suffers a -50% loss, it requires a +100% gain just to recover to its original value. Because losses are much harder to recover than gains, the key to maximizing the compounding effect is first to avoid losses. Asset allocation is the strategy that preemptively designs this loss-avoidance structure.

4. Structure Design Before Stock Selection

Many individual investors believe stock selection is the most important part of investing. However, studies analyzing real investment performance show that the contribution of stock picking to portfolio returns is only about 10–20%, while asset allocation explains 80–90% of performance. In particular, research by Brinson et al. in the U.S. has repeatedly shown that differences in institutional investors’ returns stem primarily from their asset allocation ratios.

This fact highlights that asset allocation is the essence of an investment strategy. Individual stock choices are merely tactical components laid on top of a broader structure. Choosing stocks without a structural foundation is akin to sailing without a compass. When the market crashes or a particular asset class collapses, a portfolio without an allocation structure is easily destroyed.

5. Definition and Function of Asset Classes

To design an asset allocation strategy, one must first accurately understand asset classes. An asset class is a group of assets with similar characteristics in terms of returns, risk, liquidity, and market sensitivity. Since asset classes generally have low or negative correlations with each other, combining different asset classes helps reduce the overall volatility of a portfolio.

5-1. Stocks

Stocks represent partial ownership of a company and generate returns through dividends and capital gains based on the company’s profits. They are typically the highest-returning asset class over the long term but also come with the greatest volatility. They react sensitively to company performance, industry changes, macroeconomic indicators, and policy shifts, making them inherently risky.

The primary role of stocks is to act as the growth engine of a portfolio. They offer real returns that can outpace inflation, especially during periods of economic expansion.

5-2. Bonds

Bonds are debt instruments issued by governments or corporations, promising regular interest payments and the return of principal at maturity. They generally offer lower returns than stocks but have advantages in terms of stability and predictability. Especially during times of stock market volatility, bonds serve as a capital preservation tool and are highly sensitive to interest rate environments.

Bonds function as a cushion that complements the stability and income flow of a portfolio. During market downturns, investors tend to flock to safe assets like bonds, causing bond prices to rise and offsetting stock losses.

5-3. Cash and Equivalents

Cash is the safest and most liquid asset. It includes savings, short-term government bonds, and money market funds (MMFs). Although the returns are low, there is virtually no risk of capital loss. In times of market downturns, cash plays a crucial role in capturing opportunities or securing liquidity.

Cash provides short-term stability and flexibility. In particular, during periods of high uncertainty, cash acts as strategic dry powder in an asset allocation strategy. It is also useful for rebalancing.

6. Practical Examples of Asset Allocation Strategies

Actual asset allocation strategies vary depending on an investor’s goals, investment horizon, and risk tolerance. For instance, a 30-something investor aiming for long-term capital growth and a 60-something preparing for retirement must adopt fundamentally different allocation strategies.

Examples:

• Long-term investor in their 30s: 70% stocks, 20% bonds, 10% cash
• Mid-term investor in their 50s: 50% stocks, 40% bonds, 10% cash
• Retiree at 65: 30% stocks, 50% bonds, 20% cash

Asset allocation structures can be adjusted according to age and investment purpose. Recently, automated asset allocation strategies have become available in the form of robo-advisors, goal-based portfolios, and target-date funds.

7. Risk Diversification and Correlation Management

Another key element of asset allocation is managing the correlation between asset classes. The goal is to design a portfolio where different asset classes do not fall at the same time. Traditionally, stocks and bonds have shown negative correlations, so holding both can create a structure where losses in one asset class are offset by gains in another.

However, investors should also be aware that correlations can break down in certain economic environments. For example, during the inflation shock of 2022, both stocks and bonds declined simultaneously, leading to skepticism about the traditional 60/40 asset allocation strategy. In such cases, the role of alternative assets becomes more important.

8. Systematic Investing Free from Emotional Judgment

Asset allocation is also a structural tool to minimize emotional involvement in investing. When stock prices plummet or major events occur, rather than reacting emotionally by selling or buying, executing a rebalance based on the asset allocation strategy can lead to better long-term outcomes.

Investment decisions driven by emotion generally have a negative impact on returns. In contrast, a structurally designed asset allocation strategy maintains consistent investment principles even amid external volatility. This is especially important for long-term investors.

9. Conclusion: Asset Allocation Is the Foundation of an Investment Strategy

Asset allocation is not just a technical method but a matter of investment philosophy. Predicting and selecting specific stocks or sectors can be valid on its own, but what matters more is whether the entire portfolio structure is designed to minimize losses and maximize the compounding effect.

Stocks, bonds, and cash, the traditional asset classes, each have different characteristics and roles. When combined in a balanced way, they can create a structure capable of responding to a wide range of market risks. Furthermore, an asset allocation strategy that can be flexibly adjusted according to an investor’s life cycle, risk appetite, and economic conditions should be considered a core competency for individual investors.

We now understand that asset allocation is not merely a tool for boosting returns, but a fundamental strategy for long-term survival, growth, and the design of a compounding structure. In the next chapter, we will explore how alternative asset classes contribute to the structure of asset allocation.

NEXT → PART 2 Alternative asset classes real estate, commodities and cryptocurrency