What is Asset Allocation and What is Its Purpose?

What is the best mix of Asset Classes to own to insure the best return with the least risk? This is the goal of asset allocation. The first purpose is to achieve diversification. This is investment such that the returns of any given investment group or asset class will not be correlated with the others. They will always be correlated to a degree but the purpose is normally to decrease it as much as possible. For example, stocks will all tend to move up or down together. The single most important factor in whether at stock goes up or down is where the stock market as a whole has moved. In other words, money goes into and out of the stock market as an asset class first, moving the entire market, affecting the direction of all stocks. The Bond market, however, will be less correlated with the stock market. That is, when the stock market moves up 2%, the bond market will likely not have a similar gain. To be more precise, if the stock market makes a given % daily average growth over a hundred days, the bond market will likely have made returns that bear very little resemblance to this return. Their expected correlation is moderate or low*. But, on average, one stocks correlation with another is high. Similarly, one bonds correlation with another bond is also, on average, high. The same is true for other asset classes, such as commodities and Real Estate, and others. So an investor needs to spread his/her money among the different asset classes to diversify and decrease the risk. The next question is what percentage of money to put in each class. That depends on the risk profile** of the investor. That is, how much expected return does he/she want and how much risk are they willing to take to get it? If they are willing to take more risk for a return, they will be more heavily weighted towards the stock market, commodities and real estate. If they are willing to less risk they will be more heavily weighted towards the bond market and cash equivalents (money market accounts, etc.). An example of an asset class split for a higher risk, higher return portfolio would be: 60% Stocksrn25% Bondsrn10 % Real Estatern5% Commodities/Other An example of a lower risk, lower return portfolio would be: 20% Stocksrn60% Bondsrn20% Money Market (or other interest bearing cash equivalents) A careful evaluation of the investor's risk profile needs to be made to determine how their portfolio should be divided into asset classes. It is best to consult a qualified professional to help one perform this evaluation. Then one can proceed to the next step in the investment process, which is where the investor should put her/his money within each asset class. *Why aren't bonds and stocks highly correlated (why don't they tend to move closely move together)? Stocks represent an ownership position in a company. As such, the investor can reap the full spectrum of returns from an investment, from wild growth returns, down to a total loss. Bonds are debt instruments, and are only a payment claim on a given company. Generally the long term returns on a bond security are known and fixed up front. Even if a company performs poorly, the bondholders will generally still receive the same payments and return. Of course this may not be true if the company gets into severe difficulty or bankruptcy. But the chances of not receiving this return are much less likely than poor returns on a stock. Therefore the bond market represents lower long-term expected returns, and lower risk than the stock market.