Asset Allocation

If you are new to investing, there is not much to worry or get scared about. Some the most fundamental principles of sound investing, are through ordinary, real-life experiences that have nothing to do with the stock market.

For instance, if you have ever noticed the street vendor selling vegetables; he does not sell just one vegetable; he has a mix of vegetables some in higher quantities and some in less. This may seem odd to any bystander; but there are some vegetables, say onions and potatoes that sell throughout the year and there are seasonal vegetables. By selling both items; in other words, by diversifying the product line—the vendor can reduce the risk of losing money on any given day.

If that makes sense, you've got a great start on understanding asset allocation and diversification. I will leave you with why asset allocation is so important….

By including asset categories with investment returns that move up and down under different market conditions within a portfolio, an investor can protect against significant losses. Historically, the returns of the three major asset categories (stocks, bonds and cash) have not moved up and down at the same time. Market conditions that cause one asset category to do well often cause another asset category to have average or poor returns. By investing in more than one asset category, you'll reduce the risk of losing less money and your portfolio's overall investment returns will have a smoother ride. If one asset category's investment return falls, you'll be in a position to counteract your losses in that asset category with better investment returns in another asset category.

It is the magical effect of diversification—the practice of spreading money among different investments to reduce risk that works well. Sum of parts add up more than the individual components (taking negativities into account), and for those looking at management parlance—synergy of investment tools work better than any one investment vehicle. By picking the right group of investments, you may be able to limit your losses and reduce the fluctuations of investment returns without sacrificing too much potential gain.

In addition, asset allocation is important because it has major impact on whether you will meet your financial goal. If you don't include enough risk in your portfolio, your investments may not earn a large enough return to meet your goal. For example, if you are saving for a long-term goal, such as retirement, most financial experts agree that you will likely need to include at least some stock or stock mutual funds in your portfolio. On the other hand, if you include too much risk in your portfolio, the money for your goal may not be there when you need it. A portfolio heavily weighted in stock or stock mutual funds, for instance, would be inappropriate for a short-term goal, such as saving for a family's summer vacation.