Definition: Asset allocation is how you decide how much money to put into your home equity, stocks, bonds, and other investments. Everything you own is an asset. You allocate, or divvy up your holdings, into different asset classes. The best way to reduce risk of losing wealth, and increase the return on your investments, is to be diversified. This spreads your wealth pretty much evenly into different asset classes.
Say you had cashed out your 401(k) in 2005 and put it all into a house. This would not be diversified. You would have lost at least half of it by 2008, as housing prices plummeting. If, instead, you had equal amounts of your wealth in stocks, bonds and home equity, you would have lost closer to 30%.
It is always a good idea to work with a financial planner to re-adjust your asset allocation every six months to respond to changing market conditions.
Examples:
Investors look at GDP growth to see if the economy is changing rapidly so they can adjust their asset allocation.
