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At first glance, many investors assume that the basic asset allocation decision is easy. After all, at this level you are focusing on only three choices—stocks, bonds and cash (money market funds and short-term certificates of deposit).

While the choices are few, the way you allocate your portfolio among these three categories will have by far the greatest impact on your performance of any investment decision you make, assuming that you don't violate the basic investment principles.

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Why? If you follow basic investment principles—and in particular are well-diversified within each category—you will eliminate many of the specific risk characteristics that are unique to a single investment. Most of what will remain, however, are the broad risk and return characteristics of the overall category. For instance, assuming you have a well-diversified stock portfolio of, say, 20 stocks, your decision several years ago to invest in IBM instead of Intel may have caused you to kick yourself once or twice, but it will have cost you far less than a decision several years ago to invest only 10% of your total portfolio in the stock market and the remainder in cash investments.

How does an investor make this important decision?

You should start with one of the basic investment principles: In building an investment portfolio, you are simply seeking answers to these questions: What are the risks? What risks can be eliminated or reduced through diversification and which risks will remain? What are the returns associated with the risks I will be undertaking?

This step will try to provide you with an answer to those questions by looking at the historical returns associated with the three major categories. Then, it will show you ways to balance those risks and potential returns based on your personal investment profile.

Continue to Step 2

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© 2009 The American Association of Individual Investors

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