Introduction to Asset Allocation

Back in the 1700s, a series of unfortunate horse-cart accidents among poultry farmers led to a severe egg shortage. A cry rose up from the land: "Don't put all your eggs in one basket!" It made sense, but it raised questions: Which sets of eggs should go in which baskets? Thus, the birth of egg-set allocation.

Centuries (and one bad pun) later, the advice is still good: Don't put all your eggs in one basket. But now we're talking about nest eggs -- the savings you've spent years accumulating, and which you plan to rely on for the rest of your life. As the maxim implies, diversity is the key to protecting your investments. It would be great to know whether stocks, bonds, or real estate will perform the best (and which will crash) over the next year or two -- but that is impossible. However, you can apportion your portfolio in a smart way that will offer long-term upside yet protect you from catastrophic downside (so you can afford plastic surgery on your sagging backside).

In his book The Intelligent Asset Allocator, William Bernstein points out that from 1970 to 1996, the best asset allocations focused predominantly on a mix of American small-cap stocks, Japanese stocks, and precious metals. Of course, no one in 1970 could have foreseen this, and, as Bernstein says, "This is not a portfolio that any rational person would own." Further, if in 1983 -- halfway through the period, after more than a decade of spectacular returns -- you decided to implement this strategy, you would have lost most of your money over the following years.

Our goal is not to find the very best allocation, because no one knows what that will be. Instead, we will help you choose an allocation that has performed well in various scenarios and won't give you a heart attack. We'll start with our Fool's Rules for Asset Allocation...