Asset allocation is a method of diversifying your investments to help you achieve the highest rate of return for the amount of risk you are willing to accept.
Since no one can really predict what will happen tomorrow, you need a systematic method of investing your money to reach your long-term goals. Rather than focusing on current market conditions and the short-term outlook, you need a strategy that is based on what stage of life you are at and how many years you are from starting your retirement.
Asset allocation is based on two simple concepts. First, different asset classes—stocks, bonds and cash—react differently under the same economic conditions. For example, stocks tend to do well when inflation is low and interest-rates are dropping. Bonds tend to perform well when the economy is slowing down and the price of stocks may be falling. And cash, while not a growth asset, can act as an anchor when both stocks and bonds are performing poorly.
Second, certain asset classes perform better over time than others. Stocks and stock funds are typically the long-term winners, but have the highest degree of short-term volatility. Bonds, or bond funds, with short-term maturities, typically have less price volatility with changing interest rates than bonds with longer maturities.
Here's the basic point: By selecting a combination of stock and bond funds, you smooth out the short-term volatility—the ups and downs of the markets—while seeking to achieve your long-term results.