Asset allocation is all about not putting 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.

As an extreme example, imagine that you have all of your liquid assets invested in the stock market -- which many people do in this protracted bull market. Then imagine that something untoward were to happen to the very foundations of this market. For example, millions of investors could suddenly decide that tech stocks are greatly overpriced relative to the returns shareholders are getting. So they all sell and few buy. Depending on what your holdings are and how they're affected, this could leave you hurting, indeed.

So you put your money into bonds. Yet the bond market, too, has its ups and downs. Disgusted with that market, you put your money in a money market account. However, though virtually bombproof, this market provides far lower returns. After all, less risk means lower rewards.

Moreover, a bad year in the stock market at the end of the millennium may show up as nothing more than an insignificant blip by 2010 or certainly by 2020. This is because the stock market is historically the best long-term investment vehicle -- one that can deliver an average return of more than 10 percent 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 than younger, less risk-averse individuals, and invest a significantly greater percentage in bonds.

An individual's risk tolerance and goals for returns on his or her investments are dominant factors influencing what percentage of his or her investment dollar should be put in each of the three investment categories, and the specific types of issues that should be bought in each category. Making these choices wisely delivers the maximum return within each investor's comfort zone for risk, enabling him or her to reach realistic financial goals without losing sleep.

Next: Finding the right mix