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Asset allocation? Translation: Don't put all eggs in one basket

Asset allocation? Diversified portfolio? What is this?

We have all heard the terms "asset allocation" and "diversified portfolio" before. But what are people actually talking about?

Asset allocation is how you distribute your portfolio among different investment types. There is no simple formula that can determine the right asset allocation for every individual investor. However, asset allocation is one of the most important decisions that investors make, explains Ivory Johnson, a certified financial planner and the founder of Delancey Wealth Management.

A basic, diversified portfolio might include several investment categories, such as stocks, bonds and cash. Your allocation to each of these broad categories should be based upon your investment goals, your tolerance for risk and your time horizon for needing the use of the money. In short, your asset allocation should be an outgrowth of your financial plan.

Asset allocation pie chart
Sreedhar Yedlapati | Hemera | Getty Images Plus

The three main asset classes—equities, fixed-income and cash and equivalents—have different levels of risk and return, so each will behave differently over time. Johnson explains that the benefit of using a diversified asset allocation is that the combination of many different investments have different patterns of returns. And that means the goal of portfolio diversification is to generate the highest possible return for a given level of risk, Johnson said.

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For example, a portfolio of all small-company stocks may result in greater returns than a diversified portfolio of stocks, but it is unlikely to achieve that result without significantly more risk or volatility.

The bottom line is that the process of determining a proper asset allocation, the mix of assets to hold in your portfolio, is a very personal one. The asset allocation that works best for you at any given point in your life will depend largely on your time horizon and your ability to tolerate risk.