It’s a sad commentary that these days people know more about the odds of flopping an ace in Texas Hold ’Em than they do about the far more critical issue of doubling up (or going bust) with stocks or bonds. Yet, ironically, you have a better chance of getting and keeping money through financial markets than you do playing poker.

Asset allocation is the conventional way to make investing odds work in your favor. The basic principles have been known for several decades, but lately mutual-fund companies, brokers, financial advisers, and bankers have latched on to the concept as a sales tactic, promoting asset-allocation funds for one-stop investor shopping.

Much of the information about asset allocation is confusing or even contradictory. Despite what brokers and mutual-fund companies tell you, it’s not brain surgery, either. So here are three easy steps and why they work.


Step 1: Increase diversity

Want lots of different things in your portfolio? Then buy some shares in an index mutual fund based on the Standard & Poor’s 500. It includes hundreds of stocks. So if you put all your money in it, you will protect yourself from a bankruptcy in any one (or two) individual stocks. But when the stock market tanks--as it will do every 5 or 10 years--you’ll take a dive too.

To cut down on your crash potential, you need to combine your stock index fund with investments that react differently under the same conditions. When economic growth slows or stops, company earnings fall, driving down the fundamental value of company stock shares.

Treasury bonds, on the other hand, usually increase in value when the economy slows. Bond prices are determined by interest rates, which fall when there is less economic activity. Existing bonds that are still carrying higher interest rates from good times become more valuable. In the last 80 years, stocks and bonds both suffered negative returns at the same time in just 5 years, according to Ibbotson Associates, a Chicago market-data service. In 34 years they moved in opposite directions. And in 41 they both went up, so no risk-reward trade-off there. The simplest, most common asset allocation combines stocks and bonds in your portfolio to protect you against a recession.


Step 2: Keep some cash

Your next question: What about those years when an event like double-digit inflation keeps returns for both stocks and bonds in check? To defend against that threat, you should add a money-market fund, which thrives on inflation.


Step 3. Convert risk to reward

An asset that is very risky when you bet all your money on it may be less so when you add it to the other assets in your portfolio. It’s like chemistry: You wouldn’t think of handling pure chlorine without lots of special equipment. But combined with sodium to make salt, you readily add a bit to your dinner or spread it all over your driveway when there’s ice.

Similarly, small-cap stocks can be highly volatile. Depending on which small-cap index you follow, their price swings can be twice as large as those of large-cap stocks. But mix them with other assets, and the results are surprising.

Start with a conventional portfolio that is 60 percent large-cap stocks, 30 percent bonds, and 10 percent in a money-market fund, and keep your money allocated that way for 10 years. In all the possible 10-year periods since 1926, your largest loss would have been -4 percent--in the decade from March 1928 to March 1938. Still, in 75 percent of the possible 10-year stretches, you would have increased your money by more than 69 percent. The median gain was 125 percent.

Now, replace half of the large-cap stocks in that portfolio with riskier small-cap stocks. The worst 10-year period is about the same: -5.5 percent. But in this scenario, you would have almost doubled your money 75 percent of the time and enjoyed a hefty 173 percent median return.

While a portion of small-caps can bump up your potential returns without adding much risk, other volatile assets, like a foreign index fund, can lower risk without taking much away from your expected returns. If you replaced 10 percent of the large-caps and 10 percent of the small-caps in the example above with a 20 percent international allocation, the worst 10-year period turns from a 5 percent loss to a 9.7 percent gain. And 75 percent of the time you would gain at least 86 percent.

Despite the notorious volatility of small-caps and foreign stocks, it’s rare for a portfolio with such a mix to lose money over the long term (more than 10 years). “The biggest problem investors have is that they itemize the things in their portfolio and judge their overall risk from that,” says Jerry Korabik, director, Financial Communications Group at Ibbotson. “That kind of mental accounting means you lose the opportunity to get better returns without taking on more risk.”