Investors can allocate their money among three major asset classes -- stocks, bonds, and cash -- and numerous subcategories within those asset classes.

Asset allocation is important because it determines how risky an overall portfolio is. If all of a portfolio's assets are concentrated in one area, such as stocks, it is likely to be more risky than a portfolio whose assets are spread out among diverse investment categories.

An asset allocation appropriate to an investor's goals and time horizon provides the best chance that an investor will meet his or her financial goals. In addition, an investor should examine his or her overall financial resources and personal ability to tolerate risk when making asset allocation decisions.

Diversification

Most investors are concerned about the risks associated with financial markets; namely, that their investments will lose money or will not grow enough over time to outpace inflation. Diversification is an important strategy used by investors to help reduce this risk.

Because the markets for stocks, bonds, and cash do not all move in the same direction or to the same degree, an investor's portfolio that combines these asset classes should be less risky than one that includes only one type of investment. A diversified portfolio historically produces better returns than one that is concentrated in more conservative asset classes, such as short-term bonds or cash equivalents. A diversified portfolio is also less likely to experience stomach-churning volatility than one concentrated in the most aggressive investments, such as small-cap or emerging-markets stocks.

Investors normally try to reduce risk by diversifying their exposure by asset class (stock, bond, cash equivalents), as well as their holdings within an asset class (for example, stock holdings may be diversified among large-cap stocks and small-cap stocks).

Investment Goals and Time Horizons

People invest for a variety of reasons. Some want to buy a new car next year; others are saving for a down payment on a house that they plan to buy three years from now. College tuition looms on the horizon for many families, and of course, there is retirement, which is the biggest investment goal for most individuals.

All investment goals have a time horizon, which is the length of time between now and when the money being invested will be spent. For example, if you are saving to buy a new car next year, your time horizon would be a short one. If you are saving for a down payment on a house, your time horizon might be medium-term, say three years. If you are currently 40 years old and saving for retirement, you have a long-term time horizon of about 25 years. Over time, of course, long-term goals such as retirement or funding your child's college education will become medium- and short-term goals. As your time horizon shifts, your asset allocation should shift accordingly.

For the most part, investments offering the greatest growth potential also pose the greatest risk. An investor with a short time horizon might want to minimize or avoid higher risk investments such as stocks or stock funds, because the growth potential offered by these investments over time can be offset by short-term volatility. If your time horizon is sufficiently short, say three to five years, you may wish to concentrate on more stable investments such as bond funds, or even money market accounts.

While bond funds offer no guaranteed rate of return, they are generally less volatile than stocks and usually offer greater returns than money market accounts or other cash equivalents. Those with a longer time horizon can generally afford to invest more aggressively because short-term volatility will usually be overcome by long-term growth. For long-term investors, the growth potential offered by stocks tends to offset the effects of inflation.