Asset Allocation

The term "asset allocation" is often tossed around in discussions of investing. But what exactly is it? Simply put, asset allocation is about not putting all your eggs in one basket. More formally, it is a systematic approach to diversification that determines the most efficient mix of assets based on your risk tolerance and time horizon.

Asset allocation seeks to manage investment risk by diversifying a portfolio among the major asset classes, such as stocks, bonds, and cash equivalents. Each asset class has a different level of risk and potential return. At any given time, while one asset category may be increasing in value, another may be decreasing in value. Asset allocation attempts to limit the risk by diversification. So if the value of one asset class or security drops, the other asset classes or securities may help cushion the blow.

Dividing your investments in this way may help you ride out market fluctuations and protect your portfolio from a major loss in any one asset class. Of course, it is also important to understand the risk versus return tradeoff. Generally, the greater the potential return of an investment, the greater the risk. Diversification does not guarantee a profit or protect against loss. It is method used to help manage investment risk.

As a result, the makeup of a portfolio should be based on your risk tolerance. Generally, you should not place all your assets in those categories that have the highest potential for gain if you are concerned about the prospect of a loss. It is essential to find a balance of asset classes with the highest potential return for your risk profile.

The other factors that are vital to developing an asset allocation strategy are your investment goals and time horizon. When you are considering how to diversify your portfolio, ask yourself what you want to accomplish with your investments.

© 2007 Emerald Publications