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What is asset allocation?

If you decide to put all your money in stocks or half in stocks and half in bonds, you have made an asset allocation decision.

Asset allocation describes the way in which you mix or divide your investments between the three main asset types: equities, fixed-income and cash and equivalents. Stocks represent your part ownership or equity in a company and are, therefore, an example of equities. If the company does well, the value of your stock will likely increase. Mutual funds that invest in stocks are called equity mutual funds. If you own bonds, you are lending your money to a government or a corporation. In return for allowing the use of your money, you are paid interest. This is why bonds - or mutual funds that invest in bonds -- are an example of fixed income. Cash and cash equivalents include cash itself and federal government treasury bills. Money market mutual funds are an example of cash since they typically invest in government treasury bills. What percentage of your assets should you allocate to each asset type? This will depend on your investment objectives and your risk tolerance. Risk is the potential for losing money on your investment or for tolerating fluctuations in the value of your investments. To determine your appropriate asset allocation, you need to consider issues like how long you plan to invest, your attitude to risk, your age, and whether you need current income from your investments. Historically, equities have provided the highest returns over the long term, with enough growth to more than offset the loss of buying power caused by inflation. But they tend to move up and down in value more than other investments. Over the short term, though, they have greater potential to lose money than fixed-income and cash investments. This makes equities better suited for long-term investing. Cash and equivalent investments carry the least risk of losing any of your original investment, but generally offer the lowest returns and may leave you with less buying power because of inflation. The risk - and return - of fixed-income investments tends to be less than for equities, but greater than for cash and equivalents. A balanced portfolio will have some of each type of asset. This diversification reduces risk. When one asset type may be losing money, another will likely be doing better. It's estimated that between 80% and 90% of a portfolio's return results from how you allocate your assets, rather than which particular stocks or bonds you pick. Consider seeking professional investment advice to help you determine the asset allocation that best meets your needs.