Asset Allocation and Diversification

An investment portfolio is a collection of various types of investments. You should build your investment portfolio based on your risk tolerance and two other fundamental principles: asset allocation and diversification.

Investments fall into various asset classes, such as stocks, bonds, cash equivalents, precious metals, and so on. Asset allocation is the process of determining the percentage of your investment portfolio that each asset class should occupy, based on your risk tolerance.

Each asset class provides you with a different level of risk and different levels of potential return. Owning just one asset class, such as stocks, would be risky because the value of your entire portfolio would depend entirely on the performance of that asset class. With asset allocation, your portfolio will benefit when one asset class booms and will lose only a portion of its value if another asset class crashes. The overall purpose of asset allocation is to reduce volatility so that thriving investments in one asset class potentially outweigh losing investments in other asset classes.

The following charts offer suggested asset allocations for investors with high, moderate, and low risk tolerances. For instance, based on these allocations, if you have $10,000 to invest and have a high risk tolerance, you might put $7,500 into stocks, $2,000 into bonds or real estate, and keep $500 in a money market fund.

Just as you should own investments in various asset classes, it’s also important to own various investments within each asset class. For instance, rather than own just one stock, such as Google or Pepsi Co, you should own several stocks. And rather than own just one type of stock, such as technology stocks, you should own stocks from various industries. This practice, known as diversification, has been proven to decrease risk without compromising returns over the long term.