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Allocating your investments among different asset classes is a key strategy to help minimize risk and potentially increase gains. Consider it the opposite of "putting all your eggs in one basket."

The first step to understanding optimal asset allocation is defining its meaning and purpose, and then taking a closer look at how allocation can benefit you and the right asset mix to achieve and maintain it.

The main goal of allocating your assets is to minimize risk given a certain expected level of return. Of course to maximize return and minimize risk, you need to know the risk-return characteristics of the various asset classes. Figure 1 compares the risk and potential return of some popular choices: Equities have the highest potential return, but also the highest risk. On the other hand, Treasury bills have the lowest risk since they are backed by the government, but they also provide the lowest potential return.

This is the risk-return tradeoff. Keep in mind that high risk choices are better suited for investors who have a high risk tolerance (can stomach wide fluctuations in value) and who have a longer time horizon to recover from losses.

It's because of the risk-return tradeoff - which says that potential return rises with an increase in risk - that diversification through asset allocation is important. Since different assets have different risks and market fluctuations, proper asset allocation insulates your entire portfolio from the ups and downs of one single class of securities.

So, while part of your portfolio may contain more volatile securities - which you've chosen for their potential of higher returns - the other part of your portfolio devoted to other assets remains stable. Because of the protection it offers, asset allocation is the key to maximizing returns while minimizing risk.