This chapter is targeted to those looking to determine what their ideal asset allocations should be. The author argues that higher risk leads to higher return, and therefore an investor's asset allocations should be based on his risk tolerance. Here, Malkiel divides risk into two components: willingness to take risk (i.e. how well can you sleep at night with volatile investments?) and ability to take risk (e.g. can your future employment income take care of any investment losses?).
Risk (as measured by volatility) drops based on the time horizon of the investment. For example, while in one particular year, stock market returns could be quite negative, over 25-year periods there is very little volatility in returns. As a result, investors with long time horizons can take on more short-term volatility of returns.
For investors who invest their employment income, Malkiel strongly recommends dollar-cost averaging, where the same dollar-investment is invested no matter what is going on in the market. The benefits of this strategy are that fewer (more) shares will be purchased when the market is high (low), leading to a cost-basis for the investor that is below the average market price.
Finally, Malkiel stresses that the investor's ideal asset allocation should be based on each individual's present situation, and will evolve over time. He presents some example situations where investors should hold different asset classes, and presents some asset allocations that might apply to certain groups of investors. An investor's risk tolerance is also key to choosing an asset allocation, and therefore Malkiel includes a questionnaire meant to ascertain an investor's risk profile.