Asset allocation is a method of diversifying your investments to help you work toward the highest rate of return for the amount of risk you are willing to accept. Since no one can predict what will happen tomorrow, you need a way of investing your money to pursue 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. As you know by now, stocks and stock funds have historically outperformed over the long-term but have the highest degree of short-term volatility. Bonds or bond funds with short-term maturities typically show less price volatility to 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. Since each asset class has historically achieved certain rates of return over certain periods of time, we can assume certain combinations—ratios of stocks, bonds, and cash—will produce certain long-term results based on past performance, although actual results will vary and cannot be guaranteed.
IMPORTANT NOTE: Although asset allocation strategies seek to minimize short-term volatility, they do not protect against loss in a declining market. Past performance is no guarantee of future results. Stock and mutual fund investing involves risk, including possible loss of principal. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will likely decline as interest rates rise and bonds are subject to availability and change in price.