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What is asset allocation and how does it work?

Asset allocation is a technique used to spread your investment dollars across several asset categories. The investment categories may include cash and cash alternatives, bonds, stocks, real estate, mutual funds, insurance products, or any other investment category imaginable. The general goal is to minimize volatility while maximizing return. The process involves dividing your investment dollars among asset categories that do not all respond to the same market forces in the same way at the same time. Though there are no guarantees, ideally, if your investments in one category are performing poorly, you will have assets in another category that are performing well. The gains in the latter will offset the losses in the former, minimizing the overall effect on your portfolio.

The number of asset categories you select for your portfolio and the percentage of portfolio dollars you allocate to each category will depend, in large part, on the size of your portfolio, your tolerance for risk, your investment goals, and your time horizon (i.e., how long you plan to keep your money invested). A simple portfolio may include as few as three investment categories, with a percentage of total dollars divided among, for example, cash alternatives, bonds, and stocks. A more complex portfolio may include many more asset categories or break down each of the broader asset categories into subcategories (e.g., the category "stocks" might be further divided into subcategories such as large cap stocks, small cap stocks, international stocks, high-tech stocks, and so on).

Generally, the asset allocation that best suits your needs is determined with the help of a financial professional. (Instant asset allocation can be achieved by investing in an asset allocation mutual fund.) Whether you hire a financial professional or not, be sure to periodically review your portfolio to ensure that the mix of investments you have chosen still serves your investment needs.