Since no one has a crystal ball to tell them which asset class will outperform another in any given year it is crucial that investors diversify their portfolio across several different asset classes, otherwise known as not putting all their eggs in one basket.

Asset classes tend to behave differently from one another, going up and down in separate cycles and to varying degrees, meaning their correlation is less than 1. Diversification across asset types allows an investor to capture upside gains in the market no matter which asset class currently is performing best, while simultaneously defending against hitting market bottoms. Thoughtful asset allocation can help you strike the right balance between the volatility of high-return investments and the predictability of lower-return investments.

So what is the right asset allocation? It depends on two issues. First, an investor should design a portfolio so that the expected return satisfies any cash-flow needs today and in the future. Second, any portfolio selected must be within an investor’s tolerance for taking investment risk.

As we learned from Markowitz, investors cannot ignore risk in pursuit of returns.  Risk tolerance being the degree of uncertainty that an investor can handle in regard to a negative change in the value of his or her portfolio. It is difficult to predict the level of emotional stress that an investor can endure before making a hasty decision to abandon their long-term investment plan. Each investor’s asset allocation must be within their tolerance for risk to ensure plan integrity and increase their probability of investment success.

Along with risk tolerance another important factor to consider is time horizon.  Your time horizon is the amount of time you expect this money to be invested for whether your goal is saving for education, a home or retirement each goal has a horizon. An investor with a longer time horizon may feel more comfortable taking on a riskier, or more volatile, investment because he or she can wait out slow economic cycles and the inevitable ups and downs of our markets. By contrast, an investor saving up for a teenager’s college education would likely take on less risk because he or she has a shorter time horizon.

So once you’ve chosen an asset allocation strategy when should you rebalance?  Most people chose to rebalance either based on the calendar or on your investments. Most financial experts recommend that investors rebalance their portfolios on a regular time interval, such as every six or twelve months. The advantage of this method is that the calendar is a reminder of when you should consider rebalancing, this method forces you to be disciplined in your approach.

Other experts recommend rebalancing only when the relative weight of an asset class increases or decreases more than a certain percentage that you’ve identified in advance. The advantage of this method is that your investments tell you when to rebalance again this approach helps you to stay disciplined and to stick to your original asset allocation strategy. In either case, rebalancing tends to work best when done on a relatively infrequent basis.