Asset allocation is the strategic distribution of investments across different asset classes — stocks, bonds, cash, real estate, commodities. Research consistently shows that asset allocation explains roughly 90% of portfolio return variation, far more than individual stock selection or market timing.
Your allocation should reflect your time horizon, risk tolerance, and financial goals. Younger investors typically hold more stocks for growth potential, while those closer to retirement shift toward bonds and cash for stability.
Correlation measures how two assets move in relation to each other. Perfectly correlated assets (correlation of 1) move in lockstep; negatively correlated assets (correlation of -1) move in opposite directions. Holding assets with low or negative correlations reduces overall portfolio volatility.
Modern Portfolio Theory (MPT), developed by Harry Markowitz, shows that for any level of expected return, there is an optimal combination of assets that minimizes risk. This is called the efficient frontier. MPT revolutionized how professional investors think about portfolio construction.
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