The American economy is a big place and there are a lot of different industries and market sub-categories. Drugs, medical supply, computer assembly, chip production, automotives, appliances, software services, banking, insurance, big box retailers, specialty stores, fast food, automotive, appliances, grocery stores, communications, transportation, industrial equipment, jewelry, luxury goods, agricultural goods, processed foods, the list goes on and on. These industries all swim in the same economic waters, but the financial currents affect each of them differently.

Some industries, for example, will suffer severely from rising oil prices or an increase in interest rates. A different group of companies may reap windfall profits from the same dynamic. The stocks of these affected companies will of course react quite differently. The timing and the magnitude of their relative price changes is never the same, but the trend and the relationship is real.

The world economy is an even bigger place, with non US securities accounting for more than 60% of the total capital traded. These other markets range from the relatively established businesses of Europe and Japan, to the dynamic and emerging economies of eastern and central Asia. Each of these additional markets offers common stocks as well as government and commercial bonds. Some of these markets are highly influenced by financial events in America, while others have a low correlation and a strong inclination to act independently. The advent and availability of these new markets substantially broadens the investment choices available to individuals and institutions alike.

Professional investors break the world’s stock markets and the bond markets into market sectors called ‘asset classes’ and use statistics to measure their historical correlation (tendency to move relative to one another). Guided by these sophisticated indicators, they construct portfolios by allocating the asset classes in a manner than minimizes risk and maximizes return. If the prices of asset class A always move up when the prices of asset class B move down and vice versa, then the two can offset each others price fluctuations. This will work especially well if the two asset classes move up more than they move down.

There is also a benefit to allocating between asset classes that are only slightly correlated, because the chance that both asset classes will be down at the some time is lower than the chance of a price decline in only one of the asset classes. The table below gives a general ranking of a number of asset classes. Sophisticated investment managers may segment the markets even further, or create different asset classes and sub-classes, based on their own analysis techniques.

Riskiest	Emerging Markets
	Small International
	Small U.S.
	Large International
	Large U.S.
	Real Estate Invesment Trusts
	Long-Term Bonds
	Intermediate Bonds
Safest	Short-Term Bonds & Paper

It is easy to confuse diversification and asset allocations. Technically, diversification is a method of reducing the specific risk of individual stocks down to the risk level of the underlying market (the systemic risk). Asset allocation is a tool for reducing market risk, by allocating the portfolio among different classes of assets. Because this is also a method of spreading the risk or diversifying the portfolio, financial writer sometimes use the two terms interchangeably. A practice, which is confusing to anyone attempting to learn about investment risk management.

Diversification is also used to arrange stocks in a portfolio so as to actually lowers the overall portfolio risk below the market risk. A stock with a beta of one is combined with a stock with a beta of 0.5 to produce a combined beta or .75. Whether this is truly asset allocation or diversification or some grey area combination is really a matter of semantics. What all investors need to keep in mind is that there are two kinds of risk. Specific risk and systemic risk and investment profits are highly dependent on the successful management of both.

The table above shows a simple allocation between the stocks of the S&P 500 and 5 year treasuary notes. No attempt was made to optimize the portfolio and the dividends paid by the stocks were ignored. The results above are based on annual returns. This portfolio is not recommended, it is simply an example of how various allocations of bonds and stocks affect the expected return and the portfolio risk as measured by the standard deviation of the average return.

Please note that as more bonds are added to the portfolio and less stocks is purchased, the expected return of the portfolio is falls, but the volatility of the portfolio is also reduced. An actual asset allocation for a real life investment situation would use more than two classes of assets and take into account the potential dividend income, as well as the histroical correlations between stock prices and bond prices.

Returns Are Our Goal

Asset allocation is an investment management tool that can lower systemic risk. However our real goal is returns. The whole reason for investing in the stock market is to obtain a higher return than is available from safer sources. If asset allocation squeezes all the potential gain out of a portfolio in the name of risk management, there is no point. Asset allocation portfolios measure return as a risk adjusted value. The historical average yield is discarded in favor of an indicator that reflects the level of risk that an investor must accept in exchange for a chance at the potential gain. The optimal portfolio is the one that provides the desired rate of return with the lowest possible amount of risk.

Please note that the risk level is measured statistically and based on historical relationship developed in prior economic conditions. There is not guarantee that future movements of the portfolio sectors will behave as expected. Asset allocation lowers the probability of risk. It does not eliminate it. New economic conditions or a national emergency could temporarily or permanently undermine the historical price relationship between market sectors and increase and/or lower the return of your portfolio.

Asset allocation never takes a portfolio to zero. That kind of correlation just does not exist in our complex world. In addition, assets are allocated according to the historical relationship between market sectors and different markets. Any new structural change in our economy or the economies of our competitor nations can modify or even destroy the historical relationship and push a perfectly allocated portfolio into the high risk territory.