Asset allocation is the process of diversifying potentially risky investments into a portfolio suitable for the risk tolerance of individual investors. A major function of the financial planning industry, it is the investing equivalent of the adage, "Don't put all your eggs in one basket."
The foundations of asset allocation lie in MPT, or Modern Portfolio Theory. MPT is a formal way of quantifying the risk of any given asset. It also provides tools for determining how best to combine those assets into diversified portfolios with relatively low risk. Asset allocation attempts to unite this quantitative analysis with the goals and risk tolerance of the individual investor to construct the optimum investment portfolio.
When discussing asset allocation with a financial planner, the types of investments most commonly considered include growth stocks, income stocks, government bonds, real estate, precious metals, commodities, cash and foreign currencies. In terms of risk, the safest of these are government bonds, and the riskiest are high-growth stocks which can actually go to zero. The others range in-between, depending on economic conditions.
As a general rule, asset allocation assumes that the sooner an investor may need access to the funds, the less risk they should take with their investments. It is also important to consider how long an investor has to recoup possible losses.
Since potential returns are typically inversely proportional to risk, the asset allocation for a worker near retirement will be skewed towards investments such as government bonds that offer a high degree of safety in exchange for lower rates of return. Conversely, a recent college grad has little to lose and would be better served by a portfolio that takes on high levels of risk in exchange for the opportunity to generate large returns. The asset allocation for such an individual would be more likely to contain speculative stocks and mortgaged real estate.
Some investments can be considered protection, or hedges, against unexpected events. For example, an asset allocation with significant exposure to precious metals may also have exposure to foreign currencies to hedge against a devaluation of the investor's base currency.