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Asset Allocation

What do the terms asset allocation and diversification really mean? These popular terms may be familiar to you, but lets explore them further. Basically, the concept speaks to not putting all of your eggs in one basket and making sure that you have investments in many different types of companies and styles to be able to minimize risk and benefit from those areas that may be doing well.

This concept is the basis of the Modern Portfolio Theory, a Nobel Prize winning theory based on Harry Markowitz's work at Harvard in the 1950's. Harry was commissioned to prove that the markets do not work efficiently. What he and his team came to realize is that the markets do operate efficiently and that while you have a certain probability of "picking the winner" the odds are mostly against you. Their theory, later to become the Modern Portfolio Theory states that over 91.5% of a portfolio's performance is based upon proper diversification among asset classes.

What are asset classes? Asset classes are groupings of investments that meet certain criteria, for example large cap style investments are those of companies that have more than $5 billion of common stock outstanding. The most common asset classes are Large Cap, Mid Cap, Small Cap, Fixed Income and International. These classes are further broken down into Growth, Value and various other "styles" of investing.

The Modern Portfolio Theory holds that only 4.6% of a portfolio's performance over time can be attributed to the individual investments selected or to market timing, that is guessing when investments are likely to go down (buy) or go up (sell).

As such, investments that represent many asset classes, track the market(s), and keep costs down, will position the portfolio optimally for the long term.

For more information on Asset Allocation, Diversification, Asset Classes, and styles of investing, please ask us for our analysis on these topics.

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