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What is asset allocation?


Asset allocation, at its most basic, refers to the selection of investments within a portfolio. Where it can get complicated is in the way that different types of investments – foreign and domestic stocks and bonds, gold and other commodities, real estate and even exotic stuff like hedge funds if the portfolio is big enough – are blended together into a cohesive whole. Academic studies have determined that the right mix of assets can produce better returns with lower volatility over the long haul than would be predicted from the characteristics of each asset individually. A portfolio containing about 70 percent stocks and 30 percent bonds has been found to produce the optimum gain relative to the amount of risk being taken to produce it.
Building a properly diversified portfolio may be a bit more difficult than in the past because correlations among many types of investments have risen substantially. Markets seem to be driven more by emotion now than they used to be, and that creates a tendency to buy or sell indiscriminately. When stocks of large American companies are rising or falling, stocks of smaller American companies and stocks of companies all over the world are likely to move in lockstep, as will gold and real estate, for that matter. That is likely to limit the value of diversification among many assets, while amplifying the divergence in performance between highly correlated markets and traditional havens like Treasury bonds or bank deposits. In the long run, though, a portfolio containing many disparate asset classes is still likely to provide the best risk-adjusted returns.
-Conrad de Aenlle