What is asset allocation?
Asset allocation is the strategy of dividing an investment portfolio among different categories of assets—typically stocks, bonds, and cash or cash equivalents—rather than putting all of it into one type of investment. The right mix for any individual depends mainly on two personal factors: how long the money will stay invested (time horizon) and how much loss the investor can tolerate along the way (risk tolerance), according to 
Investor.gov. Because each asset class carries a different balance of risk and potential return, allocation is one of the main ways investors manage exposure to gains and losses over time. It works alongside diversification and periodic rebalancing, two related techniques for keeping a portfolio aligned with an investor's goals. None of this eliminates the possibility of loss, since all investments involve risk, including the risk of losing some or all of the money invested.
The three main asset categories
The federal government's investor-education arm, the Securities and Exchange Commission's Investor.gov, describes stocks, bonds, and cash as the three core building blocks of asset allocation, with other categories such as real estate or commodities sometimes added. Stocks have historically offered the greatest potential for growth but also the highest volatility, meaning their value can swing sharply over short periods. Bonds generally provide more modest, steadier returns with less volatility than stocks. Cash and cash equivalents, such as savings accounts and money market funds, carry the lowest risk of loss but also the lowest return potential, and their main long-term threat is inflation eroding purchasing power rather than a market decline. Because these categories tend to respond differently to the same economic conditions, combining them in different proportions changes both the expected return and the expected volatility of the overall portfolio.
Time horizon and risk tolerance
Investor.gov describes asset allocation as personal rather than formulaic, because the appropriate mix changes with an investor's time horizon and risk tolerance. An investor with a longer time horizon, such as someone saving for retirement decades away, may be able to hold a larger share of riskier, more volatile investments like stocks, since there is more time to recover from a downturn. Someone with a shorter horizon, such as a goal five years away, generally needs to lean toward less risky holdings so a market drop does not force a loss right when the money is needed, a point Investor.gov makes directly in its guidance on gauging risk tolerance. Risk tolerance itself is defined as an investor's ability and willingness to lose some or all of an original investment in exchange for potentially greater returns. The SEC also cautions that online risk questionnaires offered by financial firms can be skewed toward products those firms sell, so investors should treat such tools as a starting point rather than a definitive answer.
Diversification
Diversification is closely related to asset allocation but operates at a finer level: it means spreading money among different investments and asset categories, and within a single asset class, to reduce the effect of any one investment performing poorly. Investor.gov explains that this can help smooth out returns and reduce concentration risk, but it cannot guarantee against loss or eliminate risk altogether. Mutual funds can offer built-in diversification across many stocks or bonds in a single purchase, though a fund with a narrow focus—such as one concentrated in a single industry—may not actually diversify a portfolio much at all. Fees and expenses charged by funds also reduce net returns over time, which is a separate consideration from the diversification benefit itself.
Rebalancing and lifecycle funds
Because different assets grow at different rates, a portfolio's actual mix drifts away from its original target over time; rebalancing is the process of restoring that intended allocation, according to Investor.gov's guidance on rebalancing. For example, an allocation set at 60 percent stocks can grow to 80 percent stocks after a strong market run, increasing the portfolio's risk beyond what the investor originally intended; rebalancing might involve selling some of the overweighted stock holdings and shifting the proceeds into underweighted bonds or cash. There is no single required schedule—experts cited by Investor.gov variously suggest rebalancing every six or twelve months, or whenever the allocation drifts past a preset percentage—but rebalancing generally works best when done relatively infrequently rather than in reaction to every market move. Investors who prefer not to manage this manually can use lifecycle or target-date funds, which automatically shift toward a more conservative mix of investments as a target date, such as a planned retirement year, approaches.
Where investor protections fit in
Asset allocation decisions are separate from account-level protections against firm failure. The FDIC generally insures eligible deposit accounts, insured money market accounts, and CDs up to $250,000 per depositor per bank, and the NCUA provides similar share insurance at federally insured credit unions, but neither insures securities or mutual funds. The Securities Investor Protection Corporation, SIPC, may replace missing securities and cash in a customer's account at a failed SIPC-member brokerage up to $500,000, including up to $250,000 in cash, but SIPC coverage does not protect against ordinary investment losses from a chosen asset allocation.
Anyone building or adjusting a portfolio can review the SEC's own explainer and worksheet in the Beginners' Guide to Asset Allocation, Diversification, and Rebalancing before making changes, and use its risk tolerance guidance to think through time horizon and goals. This article is educational only and is not investment advice.