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What is asset allocation?
Got two nickels to rub together? Keep them in separate pockets.
Asset allocation is about not putting all your eggs in one basket. It's the ultimate protection should things go wrong in one investment class or sector, as is likely to be the case from time to time.
For example, many people loaded up on technology stocks in the late 1990s. When the market corrected in 2000, many of these investors experienced steep losses.
Or, you may put your money into bonds, among the safest of investments. Yet the bond market, too, has its up and down swings. Disgusted with that market, you put your money in a money market account. However, though virtually bomb proof, this market provides far lower returns. After all, less risk means lower rewards. And even modest inflation steadily erodes the value of your cash.
Moreover, a bad year in the stock market may show up as nothing more than an insignificant blip by 2015 or certainly by 2025. This is because the stock market is historically the best long-term investment vehicle - one that can deliver an average return of roughly 10% annually for those willing to stick it out for the long haul.
In the short term, however, the stock market is more volatile than other investments. Consequently, investors with less risk tolerance - and this generally includes people who are close to retirement age - should put less money into the stock market and invest more in bonds. Younger people, however, can take on more risk because they have a longer investing horizon.
Your risk tolerance and goals will determine how much you put into each of the three investment categories. If you make careful choices with your asset allocation, you'll earn better returns without losing sleep.