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.
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 – 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). Some are highly correlated, meaning they tend to move up and down together.
If you need more information on building a diversified portfolio, take a look at our five-step guide to diversification.
How does diversification help you spread risk?
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.
Get to grips with the risks of investing your money with the Which? guide to understanding investment risk.
Will diversification protect me completely?
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. 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 might carry less risk but potentially deliver lower returns than, say, a portfolio of 100% equities.
Note that this is an example only - the behaviour of individual asset classes can change.
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, could boost returns but keep the risk at the same level as before.
Dividends can play a powerful role in generating an income from equities. Use our dividend tax calculator to find out how much you'll pay in 2017-18.
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.
Find out more about the major asset classes with our plain-English guides:
- equity investments
- commercial property
- corporate bonds and gilts
- cash as an asset class
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.
We've built a series of example investment portfolios for investors willing to take on different levels of 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.