Asset allocation is the process of determining how much of your porfolio should be invested in each type of investment security, such as stocks, bonds or real estate. This decision must be made before selecting individual securities.
Your optimal asset allocation will depend upon the return you desire to earn in order to meet your investment objectives and the risk you are comfortable with taking. Generally, investments which have a low degree of risk (such as bank savings accounts) offer a relatively low return. Investments which have a higher level of risk must offer a higher return to compensate you for this risk. For investment securities it is common to talk about long term average returns and measure risk as the standard deviation (variation about the average) of returns. A higher standard deviation means higher risk. Risk can also be measured as the percentage of years in which a loss would have occured. Long term average returns, standard deviations and percentage of years in which there was a loss for selected types of investments have been:
This data includes large and small stocks and a composite of long term and short term bonds.
Since not all investments perform the same in every year, you can improve the risk/return relationship by allocating a portion of your porftfolio into the different investment types. For example, by allocating 75% to stocks and 25% to bonds you could have acheived during this same time period an average return of about 10.5%, a standard deviation of 19% and about 25% of the years would have been losses. Alternatively if you invested 50% in each, the average return would have been about 9%, standard deviation 13% and about 23% of the years would have been losses. The asset allocation reduces return a little, but risk quite a bit.
Diversification accross different types of investments is important if you desire to acheive a better return relative to the risk of the investments. The optimal asset allocation depends upon a number of factors such as risk tolerance, time horizon and investment objective.
Please note the data presented above are based on long term historical returns and are not indicative of future returns. In fact the additional return of stocks over bonds has declined over time and stock returns are expected to be more modest in the near term.