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Asset allocation refers to spreading your investments across several types of assets, so as to decrease the overall volatility of your portfolio. This is also referred to as diversification.
Let's give a simple example. An investor in the late 90s who invested heavily in tech stocks would not have a very diverse portfolio. He may have made great returns during the tech boom, but once the bubble burst, those gains would have been largely erased. If the same investor had diversified with a combination of large-caps, small-caps, bonds and other sector stocks, his loss might not have been as great.
ETFs make it very easy to diversify, so there's no excuse not to. With virtually every sector of the economy represented by at least one ETF, you can have a complex and diversified portfolio with much less time and expense that it would have taken in the past.
The importance of asset allocation, or deciding what percentage of a portfolio to devote to various asset classes, cannot be overstated. Investors spend enormous amounts of time and money picking individual stocks, while they spend relatively little deciding what types of stock or bond to their funds. It should be just the opposite.
Investors should spend most of their time on overall asset selection and ignore individual stocks for the most part. Repeated studies(1) by unbiased university researchers have shown that about 95% of money managers' performance, for better or worse, can be explained by their selection of asset classes, not by their selection of individual stocks. When a stock performs well, invariably stocks from the same asset classes follow in parallel. All one has to do is pick asset classes well to outperform. Asset allocation is not necessarily easy, but it is less detailed and time consuming than stock picking, and it rewards the diligent investor handsomely.
Why is stock picking so unproductive? Most economists feel this is because of the enormous competition in the markets. So many experts are analyzing stocks that there is no public information others have not examined and acted on. Insider information probably would give an advantage but it is, of course, illegal to use for trading. The sheer cost of sifting through information about individual companies raises the hurdle further for stock picking funds to beat the market. One strategy to avoid the crush of competition is to gravitate to lesser-known companies, but this brings with it higher risk. The record clearly shows that on average stock picking funds do not beat the market, and there is no evidence that stock pickers who are initially successful can maintain their edge over time.
Happily, ETFs are the ideal tool for the investor focused on asset allocation. They represent just about every asset class available and are cheap, liquid, and reliable. The primary asset classes in which ETFs are available include:
ü Large Cap Stocks
ü Mid Cap Stocks
ü Small Cap Stocks
ü Growth Stocks
ü Value Stocks
ü Sector Stocks
ü International Stocks
ü Country
ü Emerging Market Stocks
ü Long-term Bonds
ü Mid-term Bonds
ü Short-term Bonds
ü Real Estate Investment Trusts
Large-cap, or stocks with high market value (capitalization), include the largest companies in a market. In the US, the Dow Jones Industrials or the S&P 500 are the most famous indexes following these.
Mid-cap, or middle capitalization stocks, are the next tier of company in terms of size, while small-cap brings up the rear with the smallest public Small stocks typically outperform over the long-term but are riskier. Some markets even have a micro-cap category.
Investors are essentially paying for the expectation of a stream of future earnings, and the growth/value demarcation is a useful one along lines of earnings.
Growth stocks represent the half of a market's companies with higher-than-average stock price-to-earnings ratios (or similar valuation ratio). This suggests an expectation that they will grow their earnings faster than average so that in coming years the price paid for earnings will ultimately be low.
Value stocks are just the opposite and have lower-than-average stock price-to-earnings ratios. Normally investors expect these firms to grow more slowly and therefore pay less as a percentage of today's earnings. Investors are comforted by knowing value companies don't need to improve earnings to meet their expectations. Growth and value can be applied to an entire market or a subset.
Sector stocks are groups of companies in the same industry. They are quite useful to play a hunch on a particular part of the economy.
International stocks are companies of non-US, usually developed economies. Europe, Asia, Australia are examples. They may span regions or individual countries only. Emerging market stocks are stocks of developing countries and are generally quite risky but often sport low price per earnings and substantial potential earnings growth. Brazil and Russia are examples.
Long-term bonds provide a guaranteed rate of return for a period (or time to maturity) of more than 7 years or so. They carry high interest rate risk, since the bonds lock in a rate for many years, a general rise in interest rates will quickly depress the value of the bonds. And vice-versa, interest rate drops will increase the bonds' value, since investors will flock to them in search of interest rates higher than in the open market.
Medium-term bonds generally pay somewhat less than long-term and are less sensitive to interest rate movements. Usually medium-term refers to 3-5 years.
Short-term bonds pay the least but are essentially impervious to interest rates. Bond dividends are considered ordinary income and taxable at relatively high rates.
Bonds may be backed by governments or corporations. US Treasuries are considered risk-free but state or city bonds may have higher yields and corresponding risk. Investment-grade corporate bonds are rated for a modest level of risk by independent ratings agencies, and they pay somewhat higher dividends than treasuries. High-yield bonds, on the other hand, are deemed risky and generally pay handsome dividends to reflect the outsize risk they present.
Real-estate investment trusts (REITs) are funds that invest in large numbers of commercial properties. They tend not to move in tandem with stocks and thus offer diversification to a portfolio. They may deliver capital appreciation but mostly generate ordinary income dividends.
There is even a gold ETF, backed by actual gold bullion stored in a vault.
These and other asset class categories may be used together to obtain finer-grained asset classes. Thus small value stocks are an asset class in their own right, and ETFs are being created every month around these subclasses. Only investable, publicly traded companies are represented, and private firms are excluded.
There are two important personal factors to keep in mind when deciding how to best diversify your portfolio. The first is age. Younger investors have more time to invest, so they can afford to take on a higher risk in exchange for greater returns. Older investors need a stable source on investment income, and can ill afford to ride out extended stock market dips, so they should choose lower risk investments.
The second factor is one's tolerance for risk. If you're concerned with pulling in the highest returns possible and can ride out the inevitable stock market doldrums, then you have an aggressive risk profile. If you can't tolerate the idea of seeing your investments lose value in the short term, or if your situation requires modest, steady returns, then you have a conservative risk profile.
Assets are divided into two broad categories: equities (stocks) and fixed income (bonds). Historically, stocks have provided the highest long-term returns, although in the short-term they can be very volatile. Bonds offer a smaller return, but are very stable and are not likely to decline with the overall market.
Depending on your age and risk profile, the percentage of stocks and bonds in your portfolio should be weighed appropriately. For higher risk and returns, stocks would comprise the largest percentage of your portfolio. For lower risk and modest returns, bonds would make up the larger percentage.
The first step towards building a diversified portfolio is to decide how to divide your portfolio into equity and fixed income holdings. A few broad examples: An aggressive investor could choose 80% stocks and 20% bonds. A moderate investor could choose 60% stocks and 40% bonds, and a conservative investor could go 40% stocks and 60% bonds.
Since the basis of a diversified portfolio is simply the percentage of stocks vs. bonds, it's possible to construct a simple, diverse portfolio using only two ETFs.
A total market ETF such as the Vanguard Total Market VIPERs (VTI) could comprise the equity portion of your portfolio. Depending on your risk profile, this could be anywhere from 40-80% of your holdings. A total bond market index such as the Lehman Aggregate Bond Fund (AGG) can comprise the fixed income portion of your portfolio.
Of course, you could substitute these for other popular, broad market indexes, such as the S&P 500 SPDR (SPY) for the equity portion, or the Lehman 20+ Year Treasury Bond Fund (TLT) for the fixed income portion. But the point is, folks, it's that easy to invest.
You could deposit $1000 in a 
ShareBuilder account, and invest $600 in an equity ETF and
$400 in a fixed income ETF. Then, let it sit for as long as possible to allow
the interest to compound over time. When you have another $1000, add it to your
investment. By performing this simple procedure, you've already achieved better
long-term returns than over 70% of the mutual funds out there. But perhaps
you'd like more flexibility in building your portfolio.
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