What it is:
How it works (Example):
Typical asset classes include stocks, bonds, real estate, cash and commodities. These groups can also be broken down further. For example, the asset class "stocks" can be broken down either by industry -- e.g., manufacturing, automotive or energy -- or by a more general characteristic of the investment -- e.g., value, growth or blue chip.
Why it Matters:
When diversifying a portfolio, it is crucial to have investments spread across different asset classes. Since investments belonging to the same asset class are expected to have correlated changes in value, having investments in only one asset class is proverbially putting all of your eggs in one basket. By diversifying across asset classes, volatility within your portfolio (e.g. risk) will decrease.
A portfolio manager will often have a prescribed allocation of investments across different asset classes based on the investor's risk preference, and then only have to choose which stocks to buy in a particular class. It is often most important to look at the general characteristics of an investment and how it fits into the overall market rather than minute details of a stock.
To read more about diversifying into different asset classes, check out Diversified Investments -- A Beginner's Guide to Protecting Your Nest Egg.