Step 2: Allocation

THE KEY DRIVER OF your portfolio’s risk and return is your asset allocation. The more you have in stocks, the higher your potential long-run return, but the rougher the ride will be. You’re fine with a rough ride? In theory, buying a 100% stock portfolio will give you the highest return.

Still, there are good reasons to hold other assets. Stocks aren’t guaranteed to win, even over long holding periods. During the 10 years through year-end 2008, the S&P 500-stock index lost 1.4% a year, including reinvested dividends, while the broad bond market returned 6.2%. Moreover, a portfolio that includes some combination of the four major assets—stocks, bonds, cash investments and alternative investments—offers three benefits that you can’t get by owning just one of these four assets.

First, by holding multiple assets, you can get the same reward with less dramatic day-to-day and month-to-month swings in your portfolio’s value, thanks to the lack of correlation among these assets. This is the magic of smart portfolio building, and it can make investing far more pleasant.

Second, by owning assets that aren’t perfectly correlated with one another, you can reduce the chance that you’ll suffer big losses. Those losses can wreak havoc with your portfolio’s long-run return, while steadier performance can help your nest egg compound at a faster rate.

Finally, you can turn this lack of correlation into additional portfolio gains—by engaging in regular rebalancing.

Next: Correlations

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