The investing process is filled with terms that you don’t hear every day. Terms like asset allocation, diversification, and rebalancing your portfolio pop up, and it’s almost like listening to a foreign language. But, there’s a trick to learning foreign languages, and it works with learning about investing too. It helps if you listen to native speakers, ask questions, practice, and try to understand.

With that in mind, I’d like to share some thoughts from Robert Stammers, who is a Chartered Financial Analyst and the director of Investor Education at the CFA Institute. My comments & “translations” are in brackets.

What is asset allocation and why is it important for investors to understand?

Investment management is not about maximizing return but about risk management or increasing the probability of achieving your financial goals. One of the best ways to reduce risk is to be diversified [don’t put all your eggs in one basket] and use proper asset allocation among various uncorrelated assets [things you own whose values don’t go up or down in relation to each other] so that your portfolio is not impacted by a significant change in any one asset.

Asset allocation involves deciding what percentage of your portfolio should be invested in different asset classes. For example, one needs to determine what percentage to invest in stocks, what percentage to invest in bonds, and so on. This is important because the data shows that a large percentage of a portfolio’s investment performance is due to the percentage invested in the chosen asset classes, not the specific investments made.

To put it simply: a good asset allocation strategy is important to ensure portfolio performance and to reduce portfolio risk.

How should investors choose which asset classes are right for a portfolio?

An appropriate asset allocation strategy is created in response to a person’s financial goals, risk tolerances, and other investment constraints. For diversification purposes it is important that assets are not highly correlated, that is to say that their returns do not move in lockstep with each other. Then it is important that investors invest in those asset classes that will not keep them up at night. It is very important that investors feel comfortable about their portfolios and that there is little emotion clouding their investment decision making. [Acting out of fear or greed is usually bad.]

When and why should an investor rebalance his or her portfolio?

There are many reasons why someone would want to rebalance their portfolio [bringing the mix of assets back into proportion]. The most common one is that the asset allocation is no longer appropriate because of natural investment growth.

For example, let us say that the long-term asset allocation strategy requires having a portfolio that is 50% stocks, 40% bonds, and 10% cash. If during the period the appreciation return on stocks far outweighs bonds and cash then at some point the percentage of stocks will be 60% of the total instead of the required 50%. Assuming that there has been no change in strategy, then the investor would either have to sell some of the investments in stocks or increase the investment in bonds, cash or both, to bring the portfolio back into line with the long-term asset allocation targets.

Another reason to rebalance your portfolio is due to expected changes in market fundamentals. If the expectation is that stocks are going to perform poorly and that bond values are expected to rise, then an investor may want to increase an allocation to bonds and decrease the allocation to stocks. The amount that one will tactically over or underweight sectors and asset classes will be a function of how active an investor may be. Some investors that are more passive may decide on a long-term asset allocation strategy and not change percentage allocations regardless of changes in the market, while other more active investors may constantly change allocations due to their expectations of future sector performance. [How often you actually change your asset allocations depends in part on how hands-on an investor you or your investment manager are.]

Another common reason to change allocation is due to a change in strategy or investment preferences. If the investment strategy changes, then the asset allocation will have to change accordingly. Let’s assume that one decides to add real estate to their portfolio because he or she thinks it will be a good performing sector in the future and will add to portfolio diversification and risk mitigation. At this point the portfolio is rebalanced to include different percentages of stocks, bonds, cash, and now real estate.

Rebalancing can also be required due to changes in preferences and constraints: let’s say that, after adding real estate to the portfolio, an investor decides to sell residential real estate…

Many people don’t realize this but a person’s salary or their future earnings stream, also known as human capital, is often an investor’s largest single asset. Now with their human capital being tied to real estate and because the investor is also a home owner, he or she decides to reduce their allocation to investments in real estate so that any downward changes in the real estate market won’t affect both their income and investments at the same time. In this case a person’s risk tolerance requires a reduction in the allocation to a particular asset class in order to reduce portfolio risk.

What resources can an investor use to maintain a healthy portfolio?

There are resources everywhere that can help investors make better investment decisions and construct appropriate portfolios. The best thing you as an investor can do to reduce risk is to get a good investment and financial education. A well informed consumer is in a much better position to determine when an investment is appropriate and when it is too risky. Try and look for information from organizations that are in the business of providing unbiased financial information and education. At CFA Institute, we provide a blog platform and other investment resources for individual investors called Inside Investing that can be reached at trustcfa.org or by following us on Twitter @CFAInvestorEd.