Asset allocation is considered an important step in building an investment portfolio. But what is asset allocation? In its simplest term, asset allocation is the practice of dividing your assets among different categories such as bond and equity. As different investments involve different risks and may perform differently under the same market condition, allocating assets to investments with low correlation can provide a better risk diversification and improve the portfolio efficiency.
The "correlation coefficient" is the parameter in determining the correlation of different investments. Correlation coefficient is a number between -1 and 1. -1 (negative correlations) means inverse relationships where investments tend to go up and down in opposition, 0 means no relationship, 1 (positive correlations) means direct relationships where investments tend to go up and down together. Bonds is considered an important part of an efficient investment portfolio as its correlation is low with equities.
An optimal investment portfolio should contain two elements: excess return under a defined risk level, less volatility under a defined return. Every dot in the chart below stands for different sharing of bonds and equities in the portfolio (every 5% equals to 1 unit). Under the identical risk level, 25% equities in the portfolio got an excess return than 100% of bonds.
Just allocate your investment portfolio with different asset classes can get excess return with lower risk. So, say goodbye with the "high risk, high return" portfolio.
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