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Madeline Simone:

What is asset allocation? Determining an appropriate asset allocation may be the most important single investment decision you make. It's determining how you're going to invest your money, how many different types of asset classes, and in what proportion. This could include stocks, bonds, commodities or even cash.

In setting an asset allocation, one of the most important principles is having a diverse mix of assets, or diversification. It's important because in a given time period, different asset classes can behave very differently. Here, we show the shifting performance of different asset classes during a recent seven-year period. Now let's focus on just one of them, for example, commodities.

In recent years, this was the best-performing asset class. And some years, it was the worst. It was never really in the middle. The point is that asset class leadership rotates over time.

So owning just one asset class would expose you to a high degree of risk. You want to own complementary ones so that your returns don't fluctuate wildly from year to year. See the diversified portfolio bar? That shows how a portfolio that was a mix of these asset classes performed during that time period, much steadier.

By definition, a diversified portfolio will never be at the top or bottom of this chart. But that steadier ride actually helps your returns over the long term. By diversifying, it evens out your returns in a given year. The process of determining which mix of assets to hold in your portfolio is a very personal one.

You have to ask yourself, what is this money ultimately for? Do I have a steady income? Do I need this money now for spending, or am I saving it? What sort of taxes am I going to have to pay?

How would I feel if the portfolio's value declined over the next three years? See, asking these sorts of questions will help you get at what sort of risk tolerance you're likely going to have in your investing. Often, individuals will ask the help of a financial advisor to help them sort through these questions and get to the answers that are right for them. So let's say you're in your 20s.

If that's the case, your time horizon is likely to be longer because you intend to be invested for a while. You don't need to tap into your investments right away. And so your risk tolerance is likely to be on the higher side. But let's say you're in your 50s or 60s and you're approaching retirement.

In that case, your time horizon is likely to be shorter because you're going to want to access these investment funds before long. Therefore, your risk tolerance is likely to be lower. So you have two very different people with very different characteristics. And so they would have two very different asset allocations.

The woman in her 20s, because she can take on a little bit more risk, would likely have a relatively-high allocation to stocks, which carry more risk but also offer greater return potential. The person in his 50s or 60s likely wants an asset allocation that's a little more stable, something that's safer. And so he might have exposure to stocks, but it would be less because he doesn't want to take on so much risk. And he'd have a higher allocation of bonds, particularly high-quality bonds, like a US Treasury, because he wants that stable, steady income that he can rely on in his retirement.

In setting an asset allocation with a financial advisor, you need to weigh your current situation and create a portfolio that's designed to do well in a variety of different environments, with the idea being that this will help your money grow over time and at a level of risk you're comfortable with.

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