Key #2

Maximize returns and minimize the ups-and-downs. By diversifying your investments across numerous asset classes your portfolio will generally experience greater returns than with conservative portfolios and more stabilized performance than with aggressive portfolios. This strategy is known as asset allocation.

In everyday terms, asset allocation simply means don't put all of your eggs in one basket. In asset allocation, if the value of one of the baskets should decline, you could still see an increase in the value of the rest of your assets in your other baskets. Asset allocation is a common financial planning practice and means dividing your assets among different broad categories of investments, including stocks, bonds and cash equivalents.

Asset allocation is a strategy where you invest your money in various asset classes rather than investing in only one. Generally, you should consider having some portion of your money in stocks, bonds and cash equivalents to maintain a balance.

What makes asset allocation work? Take a glance back at the chart at the beginning of this article. You'll notice that from year-to-year, some asset classes perform well while others lag behind. That's because asset classes don't always perform the same. Just because large-cap stocks are having a good year doesn't mean bonds will perform well. The advantage of asset allocation is that when your money is divided among different asset categories, you can take advantage of the favorable performance of one investment to help offset the poor performance of another.

How does asset allocation help maximize returns? Without a specific strategy, you might invest too conservatively, such as in cash-equivalent investments. This means that your money won't experience the larger gains more aggressive investments might offer (of course, you won't experience the drastic ups-and-downs either from having all of your assets invested aggressively).

How does asset allocation help minimize risk? Risk is the possibility that a shift in the market could reduce the value of your assets. Without specific direction, you might put all of your money in riskier investments that historically offer higher returns, but can also experience large losses. Remember the baskets above? If the value of one basket should drop, you will have the other baskets helping to balance the loss. Overall, you won't experience the large fluctuations you would otherwise experience if you had put all your money into one asset class that experienced a large drop in value. And that's an important benefit for those who lose sleep at night over their the fluctuating value of their savings.

A Blend of Investments Can Help You Capture Some of the Performance of Higher Growth Investments and the Stability of Conservative Investments

With an asset allocation blended at 50% large cap stock, and 50% bonds, you experience greater returns than a more conservative portfolio of only bonds, and less drastic fluctuations than a portfolio of only large cap stocks. This example illustrates a $100,000 investment from 1983 through 2002.

Once you've decided that asset allocation combined with a long-term investment perspective is prudent for you, the next logical step is determining the right blend of assets. The next few keys will help you when you're trying to determine the right asset allocation.

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