Asset allocation is a specific form of investment diversification. You have heard the saying, “Don’t put all your eggs in one basket” – that’s diversification. If you have a dozen eggs and you walk along with 6 in a basket in each hand and you drop one basket, 6 eggs get broken but 6 survive. If you put your savings in several completely different types of asset, the plan is that if the value of one asset happens to be going down, hopefully at the same time another will be going up. A properly diversified portfolio of investments will both reduce the risk of loss and improve the returns.

Here are some of the ways you can diversify your portfolio. Some of these are more important than others but the overall aim is to reduce risk and improve returns.

Asset Class Baskets

Different asset classes behave in different ways. Compare cash deposit accounts with property. If interest rates go up, property prices tend to go down. So your cash in the bank will earn more interest but your house may not go up as much in value.

Other main asset classes, apart from cash and property, are equities (company shares), fixed income stock (gilts and corporate bonds), commodities (oil and gold) and currencies. The theory is that a well diversified portfolio should have investments in each asset class.

How on earth does the average investor balance a portfolio between asset classes? It’s not easy but we’ll give you some rules of thumb:

Interestingly it is not a simple case of cash deposit for low risk. The whole point of asset allocation is that it’s the mix that lowers the risk.

The extent to which investments go up and down is known as volatility. The more volatile an investment the higher the potential returns but also the higher the chance they will fall. Here is a rather simplistic diagram which shows the difference between asset classes.

Although it is not as simple nor as predictable as this; the diagram illustrates that as you move to the right hand side, the potential for good returns grows but so does the possibility of a fall. If you are uncomfortable with volatility you would invest your money toward the left hand side of the diagram, i.e. cash and fixed income.

If you are investing for the long term you can afford to take a higher risk and put up with more volatility. This is because if investments fall in value you should have time for them to recover. The longer your timescale, the higher the risk, then the more your portfolio should be biased toward equity shares. If you don’t want to take much risk balance it the other way toward fixed income and cash. But keep a balance.

Suggested asset class allocations:

If you own your own property then you probably have enough of the property asset class in your overall portfolio.

You should make your decision about cash deposits by going through our 7 step decision maker in our savings and investments explained page.

Commodities are fun but a bit obscure. If you have enough money to diversify into commodities then you should probably pay for professional investment advice.

Currencies aren’t much fun unless you are George Soros so leave that to the experts. That leaves equities and fixed income. This is the crucial balance for most investors. It is also affected by whether you need income or not. We suggest that you share out the bulk of your portfolio approximately along the following lines:

• A cautious investor taking a low risk – 40% equities:60% fixed income
• A balanced investor needing an income, medium risk – 50% equities: 50% fixed income
• A balanced investor needing growth, medium risk – 60% equities: 40% fixed income
• A speculative investor taking a higher risk - 80% equities: 20% fixed income

Having made that decision, there is another level of diversification to think about (there are short cuts to these decisions – see the conclusion).

Geographical Sector Baskets

This is easier to understand. Although we live in the global economy in which the major stock markets of the world often move in similar directions, sometimes they do their own thing. Over time different countries perform in quite different ways. So part of diversification is to hold shares of companies that earn their profits in different countries.

We suggest that equities are allocated 50% into the UK and 50% internationally except for the speculative investor who should allocate 38% to the UK and 62% internationally.

So you have spread your investments between equities and fixed income and you have also spread them across different countries. What’s next?

Investment Sector Baskets

There are times when some sectors of the stock market go up and other parts go down. For example; when the internet bubble burst in 2000/2001 and technology and internet shares crashed spectacularly, shares in property companies went steadily up. The trouble is no one knows in advance which basket is going to go up and which basket go down.

So, once again, it is wise to diversify your investment across different investment sectors. If one sector goes down, some other sector may well be going up. The overall result is that you may miss some of the highs but you should also avoid most of the lows.

Investment Style Baskets

This applies to shares in a different way to fixed income stock.

Some shares are good solid, boring equities which are expensive to buy but which you expect to deliver year in, year out. Others are equities that might grow fast, maybe because they are new or recovering companies – but therefore they are more risky and volatile.

Fixed income stock varies mainly by the credit rating it enjoys. The safety of the company or organisation behind the stock. The higher the credit rating the lower the interest rate but the lower the risk too.

So to diversify your portfolio to the next level you will need to balance the equity part not just between countries and sectors but between styles of share investment.

Conclusion

Winston Churchill said, “Saving is a very fine thing, especially when your parents have done it for you”.

It doesn’t take a brain surgeon to work out that although asset allocation is a very fine thing it would be good if someone else could do it for you. Good asset allocation is neither easy nor cheap. Is there an easier way for the investor with a regular amount to save or perhaps a modest lump sum to invest?

One way of achieving some asset allocation is to use one of the a fairfunds portfolios. These are simple ethical portfolios made up of 3 leading ethical funds which cover the 3 main asset classes in proportions which match your risk: cautious, balanced for income, balanced for growth and speculative.

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