Asset allocation, or diversification, is one of the key weapons an investor has in the battle to avoid losing money, and can also be the source of the majority of their returns.Investors generally aim to spread their money among equities, bonds and other assets in order to avoid being too exposed to one investment.
The basic philosophy is to avoid putting all your eggs in one basket – don’t put all your money in one asset or sector, because if it falls, then everything falls together. Investing in different assets spreads the risk.
What you are looking for in your investments are those that do not move up and down at the same time. You want some to be going up while others are going down, and over the long-run they should all rise together.
It is important to consider diversifying within an asset class too, for example buying equity funds that invest in different countries.
Why is it important?
Protecting against losses is not the only reason why asset allocation is important.
Studies vary in the percentage but show that 50 to 90 per cent of returns are generated from asset allocation.
Often being in the right market is better than having a manager who outperforms by 1 or 2 per cent.
What are the pitfalls?
The different asset classes, generally speaking, do not move up and down at the same time, so if investors can predict the moment that, for example, the stock market will fall and the value of government bonds will rise, they can sell stocks and buy bonds, making a lot of money for themselves.
However, this is notoriously hard to do, and investors trying to "time the market" by choosing when to buy into a certain asset can get it very wrong, and incur additional costs through dealing charges.
It is very easy to be swayed by short-term concerns into buying a certain asset that is rising, only to see it go into reverse.
Setting up your asset allocation and reviewing it infrequently may be a better way to run a portfolio.
What are the basics?
Typically the longer you are investing for and the more risk you can accept, the more exposure you will have to equities.
As people get closer to retirement, they should switch into bonds and other assets with lower volatility to reduce the risk of losing money.
In recent years, however, bonds have become very expensive, and with people living for longer, some advisers say that investors should retain a significant exposure to equities even after they have retired.
Property usually has a low correlation to other asset classes, although in the crash of 2008 it suffered badly, putting many people off.
Cash is the lowest-risk asset, although it offers a minimal chance of increasing your wealth.
Your aim should be to avoid a portfolio of correlated assets. If you are not sure how to construct one, then you should consider taking advice.
How can I get someone to do it for me?
One way of allocating assets and avoiding the problem of market timing is picking a multi-asset manager who can make the decisions for you.
There are three mixed-asset sectors defined by different weightings to equities: IMA Mixed Investment 0%-35% Shares, IMA Mixed Investment 20%-60% Shares and IMA Mixed Investment 40%-85% Shares. The higher the weighting to equities, the higher the risk taken on by the fund.
There is also the IMA Flexible Investment sector, where there are no fixed limits on equity exposure.
Investors can buy multi-asset funds run by a single manager, or multi-manager funds that buy different funds that invest in different asset classes; both options leave the asset allocation decisions to the professionals.
Professional managers also have the ability and knowledge to use more complicated assets such as derivatives, which are beyond the understanding of most retail investors.
However, the funds are sold as "one-stop shops", meaning they are not tailored for your individual needs, but intended for a wide variety of clients.
They are also expensive. The fees can rise to more than 2 per cent, as the multi-manager passes on to investors the charges of the underlying funds they have bought before adding on their own fee.