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Research shows that asset allocation is the single biggest determinant of the investment performance you can expect to achieve over the long haul. So, in plain English, what exactly does ‘asset allocation’ mean? It sounds like a complex investment term that will be hard to understand. Is there any hope for the rank beginner to ‘get it’? Should you stop reading, shut down your pc, and turn on American Idol instead?

Heck no! This isn’t difficult, it’s actually quite simple. Let’s start from the beginning by defining the terms ‘asset’ and ‘allocation’.

The ‘asset’ part of the definition is easy – this is simply the chunk of money you have to invest. The money you have in your 401(k) account is an asset. The money in your checking account is an asset. The $50 savings bond your Grandmother bought you 10 years ago is an asset. Assets are good things to have.

How about ‘allocation’? Well, allocation is how you divide up your assets (your money, remember) into different investments. Allocation is deciding how much money to put where. Let’s look at some examples:

1. You put all your money in a mattress. Your asset allocation is 100% cash. Make sense? All you have is cash – you’ve put (allocated) 100% of your money (assets) into one investment type: Cash.

2. You put half your money into the mattress, and take the other half and buy shares of Ford motor company. Your asset allocation is 50% cash (the half in the mattress) and 50% stock (the other half, in Ford motor company).

Pretty easy so far, right? That’s asset allocation in a nutshell. You now understand the essential idea behind asset allocation, so let’s go a step further and talk about asset classes. Uh-oh, asset classes, is this where I start to get lost? No! Remember, you understand the core principle, so don’t start thinking this is going to get complex and scary.

Asset classes are simply the different types of ‘bins’ that you can choose to put your money into.

We talked about the most fundamental asset class already: cash. Undoubtedly this is an asset class that you are very fond of – seems we can never have enough of this asset class, doesn’t it?

At the simplest, highest level, the investing world is broken up into 2 broad asset classes: Cash (and cash-like investments, more about that in another post), and Stock (also known as equities). Let’s take a momentary diversion to talk about these 2 categories.

Cash, I think we all understand what that is. But what about stock, what the heck does it mean to own some shares of Ford stock? Does this mean you’ve loaned money to Ford?

No, it doesn’t mean you’ve loaned them money. Owning a share of Ford means you've bought a small part of the ford motor company. You are an owner of the company. You are part owner of Ford. A very, very, very small part owner. As a partial owner of Ford, if Ford does well and the company becomes worth more, then your tiny little piece of the company is also worth more. The price of your Ford share goes up, because the value of the company as a whole has gone up.

If you’ve ever pondered starting a business, owning stock is like having a business, only letting someone else do all the dirty work of running it. When you decide you don’t want this business anymore, you sell it – that’s where the stock market comes into play. It is simply a marketplace for people to enter or exit business ownership by buying or selling shares of stock.

Okay enough of our diversion. Hopefully that gives you a flavor for exactly what this whole stock business is about.

So back to our asset classes. We’ve got cash, and stock. Considering the number of companies in the U.S. and around the world, you can imagine there is a huge variation in the types of stocks available – from technology companies like Google, to old stodgy companies such as Ford, from tiny start-ups trying to make a name for themselves, to foreign companies you’ve never heard of. The universe of available stocks is huge. Staggering, really.

Do you have to learn all about all these different companies? Again, a resounding Heck No!

These companies can be broadly sorted into several buckets, or ‘bins’. Each of these ‘bins’ is considered an asset class. Here are some of the ‘bins’, or asset classes, that these stocks can be sorted into:

Large U.S. stocks

Growth U.S.

Small U.S.

Large International

Value International

Large U.S. stocks would contain companies such as Ford, General Electric, Exxon Mobil, Hershey. Large companies you’ve probably heard of.

Growth stocks are those that have typically had a high rate of growth. (Note that ‘have had’ doesn’t necessarily mean that will continue).

Small stocks, as you might have guessed, are smaller companies.

International, these are companies outside the U.S.

Ok so you get the principle – these asset classes (large, growth, etc) are categories that all the diverse stocks in the world can be sorted into. In reality there are more than the few categories mentioned above, but not a ton more.

Now, take a deep breath and review. You now know more than most so-called ‘investors’ do about asset allocation. Congratulations!

Ok, so you’ve got a bunch of asset classes (cash, large us stocks, small international stocks, etc), and a bunch of money sitting there, waiting to be invested. How you divvy up this money between these asset classes is what is important in investing, as mentioned at the beginning of this article.

But how do you decide exactly how to divide up your money between these different asset classes, and how do you actually put your money into these bins? That’s a separate topic that I’ll cover in an upcoming article.

For now, take pride in having learned the fundamental definition of asset allocation. You are on your way to being an informed, intelligent investor.