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Asset allocation and diversification explained

All you need to know about asset allocation - where to put your money and why it's important to have a range of investments in your portfolio.

In this article
What is asset allocation? What can I invest in? What is diversification?
How can I diversify my portfolio? What is the right asset allocation for me? When should I change my asset allocation?

What is asset allocation?

Asset allocation is the process of dividing your investment between different assets, such as cash, bonds, shares, and property. 

This practice helps to spread risk through diversification - in other words, by not putting all your eggs in one basket.

The types of assets you hold and the proportion of your portfolio devoted to each, also affects your investments' potential for growth - and the risk you're taking on.

Here we explain how to pick the assets that suit your investment aims.

 

What can I invest in?

Investments can generally be classed as one of the following:

 

Equities

 

Investing in companies, either by buying individual shares or through equity investment funds or investment trusts.

Equities are generally seen as having the highest risk and potential for reward, though this varies by the company, industry and country.

 

Bonds and gilts

 

Corporate bonds are portions of loans made to companies. They generally represent less risk than equity investments, but it's still possible that the firm will go bust and you won't get your money back. The risk you're taking on is usually reflected in the yield you'll receive.

Government bonds are loans made to governments; UK government bonds are known as Gilts.

Read more about these 'fixed income' investments here.

 

Property

 

Investing in commercial property, such as offices, supermarkets and warehouses, can grow your money through rental income and growth in the value of the property you own. 

However these investments can be illiquid - meaning it can be hard to sell if you need to access your money. This applies both to properties you directly own and investment funds that invest in property, several of which have been suspended in recent years.

 

Cash

 

It's important to have some money easily available for emergencies.

As an investment class, however, holding much of your portfolio in cash means it will be eroded by inflation.

Don't keep cash in a stocks and shares Isa - put it in a cash Isa or savings account so it earns interest.

 

Gold and silver

 

Gold, and to a lesser extent silver, are prized by investors for providing long term growth, often when equities investments are falling.

There is no guarantee gold and silver will continue to increase in price, however.

Nor does either metal provide a yield - you'll only see the rewards when you sell - and you'll need to pay for storage.

Read more about investing in gold and silver here.

 

There are other types of investments, such as commodities, peer-to-peer investments and cryptocurrencies, but they're less suitable for regular investors and in most cases shouldn't comprise a large portion of your portfolio.

What is 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:

  • high correlation - prices tend to rise or fall in tandem. Could include shares in industries that are closely related.
  • low correlation - very little or no relation to each other. Has often included shares and government bonds, particularly when they're in different countries.
  • negative correlation – meaning that they move in opposite ways to each other. Gold, for instance, often increases in price whilst markets fall. 

Diversifying your assets helps spread risk because you're reducing the likely 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.

Can you be too diversified?

Diversification helps lessen what's known as unsystematic risk, such as drops in the value of certain investment sectors, regions or asset types in general. 

But there are some events and risks that diversification can't help with – systemic risks. These include interest rates, inflation, wars and recession. It's rare that all asset classes go down at the same time, although the credit crisis in 2008 shows that, on occasion, this can happen.

Nor does diversification mean holding every type of asset, or an equal proportion of assets. Diversification should be balanced with your investment goals.

How can I diversify my portfolio?

Step 1: Choose a range of assets

As explained above, different asset classes behave in different ways.

Our template investment portfolios can provide a good starting point for thinking about how you could mix and match assets.

Step 2: Diversifying by sector

Say you held shares in a UK bank in 2006. Your investment may have been very rewarding, so you decided to buy more shares in other banks. 

When the credit crunch hit the following year, sparking the banking crisis, the value of your shares in this sector (financials) would have tumbled. 

So, once you've decided on the assets you want in your portfolio, you can diversify further by investing in different sectors and industries, preferably those that aren’t highly correlated to each other. 

For example, if the healthcare sector suffers a downturn, this will not necessarily have an impact on the precious metals sector. This helps to make sure your portfolio is protected from dips in certain industries.

Some investors will populate their portfolios with individual company shares directly but others will gain access to different sectors through equity funds and investment trusts.

Step 3: Spread your investments across the world

Investing in different regions and countries can reduce the impact of stock market movements. This means that you're not just affected by the economic conditions of one country and one government’s economic policies. 

However, you need to be aware that diversifying in different geographical regions can add extra risk to your investment. 

Developed markets, such as the UK and US, aren't as volatile as those in emerging markets like Brazil, China, India and Russia. Investing abroad can help you diversify, but you need to be comfortable with the levels of risk involved.

Step 4: Buy shares in lots of companies

Don’t just invest in one company. It might hit bad times or even go bust. Spread your investments across a range of different companies.

The same can be said for bonds and property. One of the best ways to do this is via an investment fund or investment trust.

They will invest in a basket of different shares, bonds, properties or currencies to spread risk around. In the case of equities, this might be 40 to 60 shares in one country, stock market or sector.

With a bond fund, you might be invested in 200 different bonds. This will be much more cost-effective than recreating it on your own and will help diversify your portfolio.

Do make sure that the funds you hold actually own different shares - that you're not buying the same company through several different funds, which wouldn't help you diversify at all.

What is 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 and how much risk you're comfortable taking to achieve that growth.

Crucially, your investments should reflect how much you can afford to realistically lose if the markets fall. 

We discuss many of these concerns in our guide to starting investing. If you can answer the above questions, take a look at our template investment portfolios for inspiration.

If you're not sure, you don't need to make all the decisions yourself; a financial adviser can help turn your aims and broader financial situation into holistic investment decisions.

Alternatively, 'do-it-for-me' (otherwise called roboadviser) investment platforms use questionnaires to understand you and suggest a readymade portfolio of funds. 

If you do understand your appetite for risk, but don't want to spend time on research, DIY investment platforms offer blended funds (funds that hold other funds) designed for specific appetites for risk.

When should I change my asset allocation?

The most common reason for changing your asset allocation is a change in your time horizon. For example, most people investing for retirement hold less in equities and more in bonds and cash as they get closer to retirement age. 

You may also need to change your asset allocation if there's a change in your risk tolerance, financial situation or your financial goals.

This information does not constitute financial advice, but can act as a helpful starting point for a conversation with a financial adviser. Read our guide to financial advice explained to find out how to find one. 

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