This post is the second post on asset allocation – feel free to read the introductory post on asset allocation to brush up.
If you own investments that all go up or down in price at the same time (ie they are correlated), then you will experience large increases and decreases in your portfolio (known as volatility). Ideally most investors want the highest return or profit with the least amount of volatility. Owning a variety of asset classes (diversification) that are non-correlated is the preferred method of investing.
Investment time horizon
The length of time until you need your investment is known as the investment time horizon. Some asset classes such as cash are very safe. If you have $5,000 in a savings account then you can sleep very well knowing that in 6 months you will still have at least $5,000 in that account. If you put your $5,000 into a riskier asset class such as stocks (ie a stock mutual fund) then in 6 months your investment might be worth more than $5,000 or it could be worth less than $5,000 (possibly a lot less).
If you are investing money you don’t need for a long time (ie 20 years) then you might consider investing it in riskier investments such as a stock mutual fund. If you need the money in a shorter time period (ie 6 months) then you should invest it in a very safe asset class such as cash (ie high interest savings account).
Sleep at night factor
It is difficult for the average investor to watch their portfolio value take wild swings every time the markets jump up and down. Lowering the amount of risk in your portfolio by increasing the safer investments (ie more bonds, less stocks) will help you sleep better at night if that is a problem.