Dear Carrie: Can you speak more on diversification and especially on asset classes? What exactly are they, and how should we spread our money out? I have come into an inheritance of about $200,000, most of which is in a money market for now. I am 55, what should I do with it to finance my retirement? -- A Reader

Dear Reader: This is a good question because it touches on two really important concepts -- diversification and asset allocation. It's also a good question because, even though a lot of people are familiar with the words, they're uncertain as to what they actually mean. So, as you've requested, I'm going to start right at the beginning by talking about asset classes.

Asset classes -- the building blocks

Asset class is simply another name for one of the major types of investments: most commonly, stocks, bonds and cash -- although it could also be real estate, precious metals or commodities. Each asset class has distinct characteristics. Stocks are the riskiest but offer the best opportunity for growth. Bonds provide a steadier but usually lower rate of return. The cash investments you currently have in a money market account are generally considered the safest, although they also offer the lowest growth potential.

Diversification -- mixing it up

Diversification -- having a variety of investments within each asset class -- is one of the most important factors in long-term investing success and is one of the best ways to control risk. That sounds like a mouthful, but it's really a simple concept that you've heard before: Don't put all your eggs in one basket.

The rationale for diversification is that you don't want your financial future to be dependent on the performance of any one single stock or bond or even one industry or sector. (Just imagine if you'd had all your money in airline or automobile stocks in the past year!) So you want to mix it up by holding a number of different investments in each asset class. This way, when one investment is down, another may be up. By diversifying, you're spreading out your risk and actually increasing your opportunity for growth. Realize, though, that in declining markets, diversification strategies do not assure a profit or protect against losses.

Asset allocation -- the right mix for you

Now we can get to your specific situation. To use your inheritance to help finance your retirement, you first need to decide just how you want to spread your money across stocks, bonds, cash or other investments -- your asset allocation. This is a very personal process and should be based on three things: your goals -- both short- and long-term; the number of years you have to invest; and your feelings about risk.

Generally speaking, the younger you are and the more time you have ahead of you to invest, the more risk you might comfortably take. This may mean owning proportionately more stocks. As you approach retirement age, it's often wise to take a more conservative approach, with a larger share of your portfolio in bonds or cash. At this point in your life, you will likely want to protect your money and make sure you have access to your cash when you need it. Continued...