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Asset Allocation

We are getting closer to the start of this maze. This step in the investment process determines the amount of money that should be invested in each of the five major asset classes. The five major asset classes are cash securities, bonds, large cap stocks, small and medium cap stocks, and international stocks. Chapter 10, “The Social Investor,” describes how asset allocation is the most important factor in determining an investor's return. Most investors spend a lot of time and effort making individual security selection choices without really considering the more important choice of asset allocation.

The objective of picking the best balance of asset allocation is to achieve the desired return goal at the lowest risk level possible. That is, you don't want to take foolish risks that are not rewarded (see Chapter 6, “Foolish Risks”). Instead, you should only take the risks in which you are rewarded, and you should only take as many of these risks as are needed to achieve your financial goal. Modern finance has developed a powerful tool to find this optimum level of allocation. The tool is called modern portfolio theory. By examining the return of these five asset classes over time, one can find the optimum allocation among the classes that both achieves the desired return and results in the most stable return over time.


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