Asset allocation is a critical component of investing success. Both research and academic studies show asset allocation to be single most significant factor in determining your financial goals. Allocation influences both the total long-term return and risk of your investment portfolio. Other factors such as security selection and market timing account for a very small percentage of your investment returns. Unfortunately, the most important decision to achieving financial success is also the least understood.

What is asset allocation? Most people confuse asset allocation with diversification. They believe it has something to do with making multiple investments among groups of similar assets. Ask investors to list the assets in which they would consider investing. Typical answers include "growth stocks", "bonds", "large caps", and sometimes "international stocks." But their diversification is limited to selection within one asset. For example, someone choosing to purchase technology stocks may invest in five or six companies ? but all within the technology industry. This reduces risk if one of the companies should fail, but is useless when the technology industry (or entire stock market) slumps.

Asset allocation goes beyond diversification to reduce risk across all type of financial assets (cash, stocks, bonds, commodities, real estate, and even venture capital or hedge funds). Investments and risk can be divided further into subcategories of stocks including large-cap, mid-cap, small-cap, value vs. growth, and international vs. domestic. Similarly, bonds can be divided into subcategories of short-term, and long-term, tax-free, high yield, convertible, emerging markets, floating rate, and international vs. domestic. Multiple combinations allow investors to allocate their portfolios into a number of asset classes and categories.

Adding high risk asset classes and investments to a portfolio may seem risky. But combining assets that behave differently, or even opposite to each other, both increases the return and lowers the risk of an entire portfolio. For example, international stocks are considered "riskier" than domestic stocks. Yet, we often see the prices of U.S. stocks go up on the same day prices of international stocks go down -- and vice versa. We call this negative correlation. Profits from one asset balance the losses from another. Combining international and U.S. stocks actually lowers investment risk by reducing daily price swings of our entire portfolio.

History demonstrates many markets exhibit similar negative price correlation. In a slumping economy, bonds vastly outperform stocks as interest rates drop. In an overheating economy, inflation helps generate stellar returns in the commodities market. But timing such events is unpredictable, and the variability of returns represents risk to any investor.