How do you achieve the greatest possible return for the lowest level of risk?

We’ve discussed many different kinds of investments, also known as asset classes: stocks, bonds,  and real estate. All these investments can be bought individually or as part of a mutual fund. And every kind of asset class reacts to financial conditions in different ways. Foreign stocks, for example, have different peaks and valleys than U.S. stocks. They correlate differently, a statistician would say. For financial purposes, lack of correlation is a very good thing.

If you choose investments that don’t all track each other, when something dramatic happens to one part of the market, you will still have money working for you in other parts. If you own different kinds of investments, the chances of you suffering a big loss at any one time go down dramatically. This is called asset allocation which is defined as: the process of systematically distributing your investment dollars among the major asset classes, stocks, bonds, and cash equivalents. Asset allocation determines whether a portfolio performs in line with an investor's financial goals.

Harry Markowitz, an economist who won the Nobel Prize for his work on Modern Portfolio Theory, showed that an allocated portfolio would give an investor the highest return for a given level of risk. Since that is every investor’s goal, the best thing you can do for yourself as an investor is to diversify.

Here is why asset allocation works. Studies have shown that portfolios with investments spread among the three major asset classes perform better and pose less risk than those that concentrate heavily on a single asset type. That's because each asset class typically responds differently to market conditions and changes in the economy. An event that triggers a decline in bond yields may stimulate a rise in stock prices. One year, large cap stocks may generate the best returns, while in another year it might be government bonds. When your portfolio includes an appropriate mix of all three-asset classes, you are less exposed to risk because declines in one asset class can be offset by gains in another. In a nutshell, asset allocation blends the characteristics of the three classes of investments to improve the chances of achieving a desired total return.

We talked about different kinds of stocks, bonds, and mutual funds earlier.

Allocating your investments involves dividing your assets into 3 simple categories:

1.       Cash and cash equivalents. Checking accounts, savings, CDs, money market mutual funds. We will also include Guaranteed Investment Contracts in this category, since they provide similar preservation of capital.
2.        Bonds and bond funds. All fixed-income investments.
3.        Stocks and stock funds. All equity investments.

Within these categories, we encourage you to diversify as much as possible.

Allocation And Diversification-what's the difference?

Now let’s discuss the difference between asset allocation with diversification. Asset allocation refers to the process of dividing your investments among the three asset classes, while diversification involves allocating your portfolio dollars among different investments within each of the major asset categories.

Diversification can be accomplished in several ways. You might, for example, diversify the investments in your stock portfolio by choosing both domestic and international stocks, large and small capitalization stocks, or growth and value stocks. You should also spread your equity investments among a number of different industries and market sectors. When it comes to bonds, you might select different types with staggered maturity dates.

For ways to keep your portfolio properly allocated among asset classes, see the section on Reallocating or Rebalancing Your Portfolio. Of course, an asset allocation strategy does not insure against market loss.