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Asset Allocation Theory Explained

The idea behind proper asset allocation is more than not putting your eggs in one basket. It is actually the process of developing an investment strategy that optimizes your investment to get the most return with the least risk.

Let's say you have two stocks that you are looking at investing in. These stocks have very similar characteristics. In fact, their stock prices generally move together. If you chose to invest in a 50/50 scenario with these two stocks, you would not accomplish the best use of your money. You might as well have chosen just one of the stocks. Now let us say that when one of the stocks goes up, the other one goes down. Thus if you invested in a 50/50 scenario, in all cases half of your investment would be going up at all times. Covariance is the statistical term used to explain how stocks are correlated to one another. The smaller the covariance, the more they are unrelated.

Another statistical term to introduce is the standard deviation. This is a measurement of the amount of risk an investment has. Let us say that a stock has an average return over the past 10 years of 15 percent. Now let's say that the stock has a 10 percent standard deviation. That would mean that there is a 65% chance that the stock will generate a return of 5% to 25% return. There is also a 95% chance the stock will generate a return of -5% to 35%.

Asset allocation theory states that you can add a second investment and get the potential return to a 18% return with a standard deviation of say 11%. You have increased your return without increasing your risk by that much. If you add two more assets to diversify your portfolio you can obtain a greater amount of return and possibly reduce your risk from investing in only one stock.

So the idea behind proper asset allocation is that you find the optimum asset classes to invest in. You should look for asset classes that are not related to each other. This can be done by using an asset allocation software. You would then find the best stocks within each asset class and also use the asset allocation calculator to determine how they are related to one another.

The optimum mix would be where the percentages of each stock purchased will maximize your return with the least amount of risk. You might invest in 10% of one stock and 20% of another stock. It depends on what the asset allocation software indicates you should do to create the best mix. In this way, you are able to create the greatest opportunity to make money with your investments. There are many different allocation software programs on the market. In another post, I will evaluate the software programs and indicate which one I feel you should purchase.