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.
You don't want a portfolio that's overloaded with a particular investment -- say, U.S. energy stocks, emerging market ETFs or municipal bonds -- no matter how well or poorly it's performing at the moment. By keeping things carefully balanced, you'll be able to endure market fluctuations without losing sleep.
In the short term, 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 investment category.
Diversifying your investment portfolio
The ultimate financial goal, of course, is retirement. How soon you retire -- and in what style -- can be greatly affected by the asset allocation decisions you make earlier in life.
Achieving the right mix can be tricky. How much should you invest in small-cap vs. mid- or large-cap stocks? With bonds, how much should be in government, corporate, or munis? Should you focus on short-, medium-, or long-term bonds? How much international exposure makes sense, and to what countries? Do you have a good balance of industries?
Rather than focus too much on the risks of a particular investment, think in terms of your tolerance for volatility. After all, one of the greatest investment risks is the risk of doing nothing -- and missing out on superior returns.
If you're retiring in 15 years and have little tolerance for wild swings, you may want to keep 60% in stocks and 30% in bonds, with 10% in a money market account.
Got 25 years to go? You might ratchet up your equities holdings to between 70% and 80%.
Only five years till you retire? You're faced with a daunting task -- allocating your assets for maximum return without betting the farm. A nasty market dip could occur immediately before retirement, leaving your nest egg drastically short.
You may want to consider consulting a qualified financial planner or adviser who can help you create a diversified portfolio that reflects your tolerance for volatility while maximizing your returns.
Before you actually invest in accordance with your newly minted allocation plan, you'll want to do something few individual investors do: Find out specifically what you own.
Most people don't know precisely what they own because their portfolios are dominated by a bunch of mutual funds. If you strip away the marketing veneer of each fund, you can find out what the fund says it invests in as well as what it actually owns.
For example, some funds may call themselves small-cap. But, these same funds may veer into large-cap territory to boost their returns if their sector is out of favor. Your fund's website should be able to give you details on its actual holdings. Many portfolio tools can also help determine what percentage of your investments are in stocks vs. bonds, etc.
The need to determine what you already own is another reason to hire a qualified financial adviser; he or she would have a good handle on most funds. As your adviser would tell you, you must break these funds into their component parts to know what percentage of your assets is in small caps versus large, or in long-term bonds versus short-term.