With literally thousands of stocks, bonds and mutual funds to choose from, picking the right investments can confuse even the most seasoned investor. However, starting to build a portfolio with stock picking might be the wrong approach. Instead, you should start by deciding what mix of stocks, bonds and mutual funds you want to hold — this is referred to as your asset allocation.

What Is Asset Allocation?

Asset allocation is an investment portfolio technique that aims to balance risk and create diversification by dividing assets among major categories such as cash, bonds, stocks, real estate and derivatives. Each asset class has different levels of return and risk, so each will behave differently over time. For instance, while one asset category increases in value, another may be decreasing or not increasing as much. Some critics see this balance as a settlement for mediocrity, but for most investors its the best protection against a major loss should things ever go amiss in one investment class or sub-class.

The consensus among most financial professionals is that asset allocation is one of the most important decisions that investors make. In other words, your selection of stocks or bonds is secondary to the way you allocate your assets to high and low-risk stocks, to short and long-term bonds, and to cash on the sidelines.

We must emphasize that there is no simple formula that can find the right asset allocation for every individual — if there were, we certainly wouldnt be able to explain it in one article. We can, however, outline five points that we feel are important when thinking about asset allocation:

1. Risk Vs. Return

The risk-return tradeoff is at the core of what asset allocation is all about. Its easy for everyone to say that they want the highest possible return, but simply choosing the assets with the highest potential (stocks and derivatives) isnt the answer. The crashes of 1929, 1981, 1987, and the more recent declines of 2007-2009 are all examples of times when investing in only stocks with the highest potential return was not the most prudent plan of action. Its time to face the truth: every year your returns are going to be beaten by another investor, mutual fund, pension plan, etc. What separates greedy and return-hungry investors from successful ones is the ability to weigh the difference between risk and return. Yes, investors with a higher risk tolerance should allocate more money into stocks. But if you cant keep invested through the short-term fluctuations of a bear market, you should cut your exposure to equities.

2. Dont Rely Solely on Financial Software or Planner Sheets

Financial planning software and survey sheets designed by financial advisors or investment firms can be beneficial, but never rely solely on software or some pre-determined plan. For example, one old rule of thumb that some advisors use to determine the proportion a person should allocate to stocks is to subtract the persons age from 100. In other words, if youre 35, you should put 65% of your money into stocks and the remaining 35% into bonds, real estate and cash.

But standard worksheets sometimes dont take into account other important information such as whether or not you are a parent, retiree or spouse. Other times, these worksheets are based on a set of simple questions that dont capture your financial goals. Remember, financial institutions love to peg you into a standard plan not because its best for you, but because its easy for them. Rules of thumb and planner sheets can give people a rough guideline. but dont get boxed into what they tell you.

3. Determine Your Long- and Short-Term Goals

We all have our goals. Whether you aspire to own a yacht or vacation home, to pay for your childs education or to simply save up for a new car, you should consider it in your asset allocation plan. All of these goals need to be considered when determining the right mix.

For example, if youre planning to own a retirement condo on the beach in 20 years, you need not worry about short-term fluctuations in the stock market. But if you have a child who will be entering college in five to six years, you may need to tilt your asset allocation to safer fixed-income investments.