60 second guide to asset allocationGet the right mix for your investment portfolio

27 August 2011

Asset allocation explained

Asset allocation can help you meet your financial goals and spread risk

It's been a tricky summer for investors. Stock markets have plummeted - the FTSE 100 has fallen by 14.4% since the beginning of July, while the S&P 500 in the US has dropped by 13.4%. 

With interest rates still at a record low of 0.5%, savers who have turned to investment for a better rate of return would have received a nasty shock over the past couple of months.

Getting diversified

Few things are predictable when it comes to investing your money but it's often said there's only 'one free lunch' in investment - and that's asset allocation and diversification. It involves getting the right mix of investments for your financial goals and how much risk you're willing to take on to achieve those goals. Diversification also enables you to spread risk, protecting your portfolio against the worst falls in individual markets. 

With this in mind, Which? Money gives you the low down on asset allocation and diversification, and how you can apply it to your investment portfolio. 

What is asset allocation?

Asset allocation is the process of dividing your investment between different asset classes such as cash, bonds, equities (shares in companies) and property. The idea behind allocating your money between different assets is to spread risk through diversification - the idea of not putting all your eggs in one basket.

Tell me more about diversification

To benefit from diversification, you need to invest in assets that behave differently from each other. Each asset type has a relationship with others – some have very little or no relation to each other (known as a low correlation), whereas others are inversely connected – meaning that they move in opposite ways to each other (called a negative correlation).

How does diversification help you spread risk?

Diversifying your assets helps spread risk because you're lessening the potential for losses. If you had all of your money invested in one asset, sector, or region and it began to drop in value, your investments would suffer. 

By investing in assets that aren't related to each other, while one part of your investment portfolio is falling in value, the others aren't going the same way. Some assets will actually go up in value when others decrease.

Will diversification protect me completely?

Diversification helps lessen what’s known as unsystematic risk, like drops in the value of certain investment sectors, regions or asset types in general. But there are some events and risks that diversification cannot help with, or systemic risks. These include interest rates, inflation, wars and recession. 

It’s rare that all asset classes can go down at the same time, although the credit crisis in 2008 shows that, on occasion, this can happen. This is important to remember when building your portfolio.

What is the benefit of asset allocation?

Not only does asset allocation naturally spread risk, it can help you to boost your returns while maintaining, or even lowering, the level of risk of your portfolio. If you had a portfolio made up of 100% in bonds, it would carry less risk but deliver lower returns. 

The addition of 10% in equities will increase the risk of your portfolio but also increase your potential returns, as the two assets have a negative correlation (one generally moves up when the other moves down). Adding in some property, which is unrelated to equities and bonds, can boost returns but keep the risk at the same level as before.

What assets should I invest in?

To properly diversify, you should start with the four main asset classes: cash, bonds, equities and property. But even then, it's important to diversify not only between asset classes, but also within asset classes. This might mean investing in equities in different regions and industries, or in a mix of corporate bonds and government bonds. 

You can further spread risk by adding in other assets with little relation like commodities (gold, oil, gas) or alternatives, like hedge funds.

How do I decide the right asset allocation for me?

Determining the right asset allocation depends on how much time you have to invest, how much growth you need to achieve to meet your financial goals, how much risk you're comfortable taking to achieve that growth and, crucially, how much you can afford to realistically lose if the markets fall. A good, independent financial adviser can help you do this. 

When should I change my asset allocation?

A change in the length of time you have to invest, or a shift in your financial situation or goals may prompt you to want to change your asset allocation. A good example of this is people that have been investing for retirement – they tend to hold less in riskier equities and more in lower risk assets like bonds and cash to preserve the value of their investments.

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