Want to grow rich – or maybe stay rich? The best thing you can do is fill your portfolio with the right mix of stocks, bonds, and cash. It doesn’t matter if you are starting a 401(k) or 529, building a small portfolio of funds, or managing a large inheritance. And don’t worry, it’s easy.

Asset Allocation: The Most Important Part of Investing

“Asset allocation” means dividing your investment portfolio between stocks and bonds and cash. It is as simple as deciding to put 75% of your portfolio in stocks and 25% of your portfolio in bonds. However, certain mixes of stocks and bonds are better for some people than others. The tricky part of asset allocation is figuring out what mix of asset classes works best for you.

The term “asset class” refers to a group of investments that behave similarly in the markets (go up and down at the same time) and are regulated similarly. Most asset classes fall into two major categories: Equity (private and public stocks) and Fixed Income (bonds and cash). Each of these asset classes will introduce a different amount of return potential and risk potential into your portfolio.

What do “return” and “risk” mean? Return is the amount that an investment increases or decreases in value over time. Risk usually refers to an investment’s volatility. Still sound like gobbledygook? Volatility measures how much and how often an investment changes value over time. For example, an investment that returns 10% one day, returns -4% the next day and returns 20% the following day is more volatile during this period than an investment that returns 2% each of these three days. The more an investment’s value jumps around, the more volatile it is, and the more risky it is.

Historically, asset classes that posted higher returns did so with more volatility. In other words, higher returning investments are usually more risky. For example, U.S. stocks greatly outperformed U.S. bonds over the 15 years through September 2007. However the U.S. stock market went through bigger upswings and downswings than the U.S. bond market did during this time. You probably want to invest a portion of your portfolios in U.S. stocks in order to benefit from their high return potential. But you also want to reserve a piece of your portfolios for lower-returning, less risky, less sexy bonds. Doing so will likely protect your portfolios when the stock market is down. As a result, your portfolio will deliver more consistent, predictable returns.

*U.S. stocks represented with S&P 500. U.S. bonds represented by Barclays U.S. Aggregate Bond Index.

Diversification: don’t put all your eggs in one basket

“Diversify” is to financial planners like “Yankees suck” is to Red Sox fans. It’s their mantra, their practice, the sound of their being. And it should be yours too.

Diversifying a portfolio means investing in a variety of asset classes. Asset classes tend to grow and shrink in value at different rates at different times. For example, sometimes when U.S. large-cap stocks are doing well, U.S. small-cap stocks are doing less well, and U.S. bonds are faring poorly. The next year, U.S. large-cap stocks might be mediocre, U.S. small-cap stocks might be soaring with high returns, and U.S. bonds might be in the tanks. By holding a collection of these investments, rather than just one, you can decrease the chance that your portfolio will plummet or skyrocket unexpectedly. In other words, you can trim your portfolios’ risk by improving the chance that at least one investment will do well regardless of market conditions. On the flip side, diversification can dampen returns as you also increase the chances for one investment to turn south.

Cash is represented by three-month T-bills; bonds by five-year Treasuries; stocks by the S&P 500.
Treasury securities are guaranteed by the U.S. government as to the timely payment of principal and interest if held to maturity.
Source: Center for Research in Securities Prices (CRSP), Compustat, Federal Reserve, and Bernstein

It is possible and important to diversify within each broad asset class. Some pieces of each market have a history of performing in quite different ways.  For example, when U.S. growth stocks are in favor, U.S. value stocks tend to underperform. When large-cap stocks perform well, small cap stocks tend to lag. These types of assets have low, or negative, correlations.   (See graphs of these “lowly correlated” asset classes below.).

*Smoothed on a trailing 12-month basis
Value is represented by the MSCI World Value Index, growth by the MSCI World Growth Index.
Source: Morgan Stanley Capital International and Bernstein