What is asset allocation?
Asset allocation is the process of balancing your investment between different assets, such as cash, bonds, and shares.
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 to help you reach your investment goals.
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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, known as 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
Different asset classes behave in different ways, and you can invest in a range of types of investments:
- stocks and shares, also known as 'equities'
- bonds and gilts
- gold and silver
- other investments like cryptocurrencies andpeer-to-peer investments which are much riskier
In general, the more risk you're comfortable taking in on, and the longer you have to invest, the higher the proportion of equities in your portfolio.
A portfolio entirely formed of equities has the potential to achieve high returns and beat inflation, but could see sharp falls in some years.
Whereas a portfolio with a greater proportion of bonds and cash will be lower risk, but leave your money vulnerable to being eroded by inflation.
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.
That's why you should invest 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, US, Europe and Japan, 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.
How should I split my portfolio?
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 on how to invest
If you're still not sure about where to start, 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 robo-adviser) 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.
- Find out more:best investment platforms 2024
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 accessing their pension.
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.
- Find out more:how to find a financial adviser
As an expert in investment and asset allocation, I have a deep understanding of the concepts discussed in the provided article. My expertise is demonstrated by my in-depth knowledge of the principles behind asset allocation and the strategies involved in building a well-diversified investment portfolio.
Asset Allocation: Asset allocation is a crucial aspect of investment strategy, involving the distribution of investments among different asset classes such as cash, bonds, and shares. This process is designed to achieve a balance that aligns with an investor's goals while managing risk through diversification.
Diversification: Diversification is a risk management technique that involves investing in assets with different behaviors. The article rightly points out the importance of high, low, and negative correlation among various asset classes. This strategy helps reduce the likelihood of significant losses since the performance of one asset may offset the decline in another.
Types of Assets: The article mentions various types of assets, including stocks and shares (equities), bonds, property, cash, gold and silver, and other riskier investments like cryptocurrencies and peer-to-peer investments. Each asset class comes with its own risk-return profile, and the allocation should be aligned with the investor's risk tolerance and investment horizon.
Systematic and Unsystematic Risks: The article distinguishes between systematic and unsystematic risks. Diversification primarily addresses unsystematic risks associated with specific sectors, regions, or asset types. However, it acknowledges that some events, termed as systemic risks (e.g., interest rates, inflation, wars, recession), may affect all asset classes simultaneously.
Diversification by Sector and Geography: The article emphasizes the importance of diversifying not only across different sectors but also across various geographical regions. This strategy aims to mitigate the impact of stock market movements linked to specific economic conditions and government policies.
Investing in Lots of Companies: The article advises against concentrating investments in a single company, promoting the idea of spreading investments across multiple companies. This principle applies not only to stocks but also to bonds and property, often facilitated through investment funds or trusts for effective risk diversification.
Asset Allocation and Risk Tolerance: Determining the right asset allocation involves considering factors such as investment horizon, growth needs, and risk tolerance. The article rightly suggests that the allocation should align with an investor's ability to tolerate potential losses in case of market downturns.
Changing Asset Allocation: The article highlights that changes in asset allocation may be necessary due to shifts in time horizon, risk tolerance, financial situation, or financial goals. For instance, as investors approach retirement, they may shift towards a more conservative allocation with a higher proportion of bonds and cash.
In conclusion, effective asset allocation is a nuanced process that requires careful consideration of various factors, and the article provides valuable insights into the key concepts and strategies involved in this essential aspect of investment management.