You have heard it before when people tell you that something cannot miss, it is surefire and there is no way you can lose money!!! Phrases like this were passed around like candy in the late nineties and sure enough people saw record breaking highs. Fortunes were built overnight and people became millionaires during the dot com gold rush. If you were not in technology you were going to miss the boat! Investments that featured technology investments became the center of many portfolios. But, it came to an end, and that end saw many lose and lose big.

Now that the smoke has cleared you hear a lot about diversification and asset allocation. What does it all mean? To understand asset allocation you need a basic understanding of different sectors and how you can participate in the market. One of the most common ways is owning stock. That is, buying a piece of a company and assuming some of its risk. Owning stock usually gives the holder certain rights along with the possibility of gain in the form of dividends and capital appreciation. One of the defining characteristics of the stock market is based on the concept market capitalization. That is the company value determined by multiplying the number of outstanding shares of stock by the current market price for one share.

Market capitalization determines what sector a company falls under. Large cap companies have a market capitalization of $5 billion or more. These companies have a tendency to have steady growth with less volatility. Mid Cap companies are corporations whose market capitalization is between $500 million and $5 billion. There is more exposure to volatility with a greater chance for gain or loss in this sector. Small Cap companies are defined as small, publicly traded corporations, with a total market value, or capitalization, of less than $500 million. Essentially, with smaller market capitalization comes the potential for greater returns but with greater risk.

Now the other side of investing is loaning money to an entity in the form of bonds. In this scenario the issuer pays interest on certain dates and redeems by paying the owner principal at maturity. One of the concepts to understand in regards to bonds is the par value, that is, the face amount of the bond. The interest rate that the issuer must pay is influenced by many factors, such as market interest rates, the length of the term and the credit worthiness of the issuer. The most common type of bonds are issued by companies, municipalities and the federal government. Since economic factors are likely to change over time, the market value of a bond can change after issue. Because of these differences bonds are priced in terms of a percentage of par value. They are not necessarily issued at full face value but reach par at the moment before their term expires. As far as investments they are stable but usually do not have the same potential for gains as money that is invested in the stock market over a long period of time.

Understanding asset allocation is knowing that stocks and bonds operate as opposites. As the value of stocks go up, the value of bonds go down and vice versa. Take, for example, in the year 2001 when the stock market dropped the general response was the rise in value of bonds. Now, with the recent rise in the market and interest rates the bond market continues to deflate. With this in mind, asset allocation really means the ratio of equities to bonds (ownership in an entity vs. loaning an entity money) in accordance to what type of investor you are and what your time horizon is for that investment. This helps determine what is commonly referred to as: risk tolerance. That is, your ability as an investor to endure declines in the prices of investments while waiting for them to increase in value.

We have now come to the two driving factors when selecting your where to put your money. The time frame and risk tolerance for that particular investment. If your time horizon is short and you need liquidity a CD or money market account may be the ideal solution. If it is money for retirement and you are relatively young more aggressive stock holdings make more sense. The key is realizing that having only one type of investment can be detrimental. Go too conservative and you probably won't get a satisfactory return. Go too risky and you could lose it all right when you need it most. Proper asset allocation gives you exposure to market gains offset with the stability of bond holdings over time. By doing this you are allowing the market to work over time but not over-weighting yourself in only one or two sectors. One way to think of it as a means of checks and balances to help you get the most steady rate of return.

Keep in mind that there are other investments such as: international stocks, cash holdings, real estate and life insurance cash values that can play a role when looking at asset allocation within a household. Always consult with a financial professional when investing to help you with your risk tolerance and asset allocation mix. A good advisor will take the time to assess your current situation and your goals to assist you with putting together an appropriate portfolio.