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How do you achieve the greatest possible return for the lowest level of risk*?

There are many different kinds of investments, also known as asset classes: stocks, bonds, commodities such as gold and grain, real estate, antiques, and collectibles. Except for things like antiques and collectibles, all these investments can be bought individually or as part of a mutual fund. And every kind of asset class may react to financial conditions in different ways. Foreign stocks, for example, may have different peaks and valleys than U.S. stocks. They may not correlate. For financial purposes, lack of correlation is a good thing.

If you choose investments that don't track each other, when one part of the market falls, you may still have money working for you in other parts. If you own different kinds of investments, the chances of you suffering a big loss at any one time go down. This is called asset allocation, which is defined as: the process of systematically distributing your investment dollars among the different asset classes, the major ones being stocks, bonds, and cash alternatives. Asset allocation is a large factor in determining whether a portfolio performs in line with an investor's financial goals.

Harry Markowitz, an economist who won the Nobel Prize for his work on Modern Portfolio Theory, showed that an allocated portfolio would give an investor more return without necessarily taking on more risk. Since that is every investor's goal, an important task as an investor is to allocate your assets.

Here is why asset allocation works. Studies have shown that portfolios with investments spread among the three major asset classes perform better and pose less risk than those that concentrate heavily on a single asset type. That's because each asset class typically responds differently to market conditions and changes in the economy. An event that triggers a decline in bond yields may stimulate a rise in stock prices. One year, large cap stocks may generate the best returns, while in another year it might be government bonds. In a nutshell, asset allocation blends the characteristics of the three classes of investments to improve the chances of achieving a desired total return.

Allocating your investments involves dividing your assets into 3 simple categories:

1. Cash and cash alternatives. These include checking accounts, savings, CDs, money market mutual funds. We also include GICs in this category, since they provide similar preservation of capital.
2. Bonds and bond funds. These are all fixed-income investments.
3. Stocks and stock funds. These are all equity investments.

Within these categories, you should try to diversify as much as possible.

Allocation and Diversification: What's the Difference?

Asset allocation refers to the process of dividing your investments among the three asset classes, while diversification involves allocating your portfolio dollars among different investments within each of the major asset categories.

Diversification can be accomplished in several ways. You might, for example, diversify the investments in your stock portfolio by choosing both domestic and international stocks, large and small capitalization stocks, or growth and value stocks. You might also spread your equity investments among a number of different industries and market sectors. When it comes to bonds, you might select different types with staggered maturity dates.

For ways to keep your portfolio properly allocated among asset classes, see the section Portfolio Management.

Fund Overlap

If mutual funds are part of the investments you hold, their composition also needs to be evaluated in your asset allocation strategy. Remember, asset allocation looks at all of your assets, including those in tax-deferred accounts such as 401(k) plans and IRAs.

One thing to be wary of when figuring out your asset allocation strategy is fund overlap. Fund overlap is the amount of a stock—say General Electric stock—owned by each of the mutual funds in your portfolio. To determine the individual stocks in which each of your mutual funds is investing, look in the annual or semi-annual report, which lists all of the stocks in which the mutual fund has invested. You might be amazed to see what you actually own. Another way to see the top holdings of a mutual fund is to look at the Morningstar report for that fund.

Even if you have taken the time to look at the stocks in your funds, chances are you have not calculated the amount of fund overlap that exists. For example, you may own a value fund, a balanced fund, a global fund, a growth fund, and a technology fund and all five of these funds might have the same stock as one of its major holdings. Chances are, you purchased these different targeted funds, and perhaps from different fund companies, seeking a diversified portfolio—only to end up holding a lot of the same stock. Thus, you may not be as diversified as you originally thought. Unfortunately, stock overlap is quite common. The goal is to make sure you do not have too much of it.

Fund Family Overlap

Another thing to consider is fund family overlap. Even if you have spread your investments between different fund families, you may still have some overlap, but it should be less than if you were to invest in different mutual funds within the same fund family. This is due to the fact that sometimes fund managers within a fund family share ideas, expertise, research, etc. So if one fund manager favors a stock, he/she shares the information and favoritism with the other fund managers "in the family." This can result in many of the funds in a family holding several of the same holdings.

So if overlap is a concern to you, you can try to reduce it by investing in different fund families. It's okay to have slight overlap between your funds, it's almost impossible to avoid it completely. Be aware of the underlying holdings in each of your funds and if the overlap becomes material, it might be time to reallocate your holdings. Knowing your holdings and overlap might make the difference in achieving gains or minimizing your losses the next time the market takes a downturn.

Age and Diversification

How you diversify your assets depends on your age. Although investing is for the long-term, your "long term" becomes shorter as you get older. As your time horizon changes from long-term to intermediate-term, you may want to move some of your assets (the amount you will need in the next five years) into a mix of short- and intermediate-term bond funds and cash.

IMPORTANT NOTE: Asset allocation does not ensure a profit or protect against a loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.

* Asset allocation does not ensure profit or protect against market losses.