Asset allocation forms the backbone of any successful investment strategy. As someone who has spent years analyzing portfolios, I find the American Association of Individual Investors (AAII) approach to asset allocation both practical and research-backed. In this deep dive, I will unpack AAII’s methodology, compare it to alternatives, and demonstrate how you can apply it to your portfolio.
Table of Contents
What Is AAII Asset Allocation?
The AAII advocates for a disciplined, model-based approach to dividing investments across asset classes like stocks, bonds, and cash. Unlike speculative strategies, AAII’s framework relies on historical performance, risk tolerance, and long-term financial goals.
The Core Principles
- Diversification Reduces Risk
Modern Portfolio Theory (MPT) shows that combining uncorrelated assets lowers overall portfolio volatility. The AAII builds on this with its model portfolios, which vary based on investor profiles. - Risk Tolerance Dictates Allocation
An aggressive investor might hold 80% stocks and 20% bonds, while a conservative one may flip that ratio. The AAII provides five distinct models:
- Aggressive (100% stocks)
- Moderately Aggressive (70% stocks, 30% bonds)
- Moderate (60% stocks, 40% bonds)
- Conservative (40% stocks, 60% bonds)
- Income-Focused (20% stocks, 80% bonds)
- Rebalancing Maintains Discipline
Markets shift allocations over time. Rebalancing annually ensures your portfolio stays aligned with your risk tolerance.
The Math Behind Optimal Asset Allocation
The AAII’s approach borrows from Harry Markowitz’s Efficient Frontier, which maximizes returns for a given risk level. The expected return E(R_p) of a portfolio with two assets (stocks and bonds) is:
E(R_p) = w_s \times E(R_s) + w_b \times E(R_b)Where:
- w_s = weight of stocks
- E(R_s) = expected return of stocks
- w_b = weight of bonds
- E(R_b) = expected return of bonds
The portfolio risk (standard deviation) is:
\sigma_p = \sqrt{w_s^2 \sigma_s^2 + w_b^2 \sigma_b^2 + 2 w_s w_b \sigma_s \sigma_b \rho_{sb}}Where \rho_{sb} is the correlation between stocks and bonds.
Example Calculation
Assume:
- Stocks: E(R_s) = 8\%, \sigma_s = 15\%
- Bonds: E(R_b) = 3\%, \sigma_b = 5\%
- Correlation: \rho_{sb} = -0.2
For a Moderate (60/40) portfolio:
E(R_p) = 0.6 \times 8 + 0.4 \times 3 = 6\% \sigma_p = \sqrt{(0.6^2 \times 15^2) + (0.4^2 \times 5^2) + (2 \times 0.6 \times 0.4 \times 15 \times 5 \times -0.2)} = 8.7\%This shows how diversification reduces risk below the weighted average of individual volatilities.
Comparing AAII Model Portfolios
| Portfolio Type | Stocks (%) | Bonds (%) | Expected Return | Risk (Std Dev) |
|---|---|---|---|---|
| Aggressive | 100 | 0 | 8.0% | 15.0% |
| Mod. Aggressive | 70 | 30 | 6.5% | 10.1% |
| Moderate | 60 | 40 | 6.0% | 8.7% |
| Conservative | 40 | 60 | 5.0% | 6.2% |
| Income-Focused | 20 | 80 | 3.8% | 4.5% |
Which One Should You Choose?
Your selection depends on:
- Time Horizon: Younger investors can afford more stocks.
- Risk Appetite: Can you stomach a 20% drop in a year?
- Financial Goals: Retirement needs differ from short-term savings.
Rebalancing: The Unsung Hero
Markets drift. Without rebalancing, a 60/40 portfolio could become 75/25 after a bull run, increasing risk. AAII recommends annual rebalancing.
Case Study: The 2008 Crisis
A Moderate (60/40) portfolio in 2007 would have suffered less than a 100% stock portfolio. By 2009, rebalancing would have forced buying stocks low and selling bonds high, improving long-term returns.
Criticisms and Alternatives
1. Static Allocation vs. Dynamic Strategies
Some argue AAII’s fixed allocations ignore macroeconomic shifts. Tactical asset allocation adjusts based on market conditions.
2. Ignoring Alternative Assets
Real estate, commodities, and cryptocurrencies aren’t in AAII’s traditional models.
3. Over-Reliance on Historical Data
Past performance doesn’t guarantee future results. Low bond yields today challenge traditional assumptions.
Final Thoughts
The AAII’s asset allocation models provide a robust starting point. I’ve used them myself to guide clients toward balanced, risk-adjusted portfolios. However, personalization is key—adjust based on your unique circumstances.
