What is asset allocation?

Asset allocation is simply the decision of what sort of assets the portfolio will be invested in.  One of the primary tools of asset allocation is diversification, which is the most common and effective form of risk management. A diversified portfolio has lower risk and generally quite good returns compared to a portfolio comprising entirely one asset class.

If you put some money into international shares, some into domestic shares, some into bonds, some into mortgages, some into property and a bit into cash, by adjusting the actual mix you can achieve a portfolio with superior risk and return characteristics to a single sector portfolio.

Why is asset allocation important?

In Peter Bernstein's excellent book on Risk, Against the Gods: The Remarkable Story of Risk, the author makes the following statement:

The essence of risk management lies in maximising the areas where we have some control over the outcome while minimising the areas where we have absolutely no control over the outcome and the linkage between effect and cause is hidden from us.

Asset allocation is important because in practice virtually everyone fails at market timing and the majority fail at security selection. From a broad strategic view each asset class has its pros and cons. Shares shine when inflation is low but barely keep up in times of high inflation, property does well in times of high inflation but doesn't do much the rest of the time, bonds provide a good income yield but no inflationary protection at all, though they are somewhat more stable, and cash isn't spectacular from an investment point of view but still has a role as a depository for liquid funds.

If you can't time the market well, and you haven't established any great skills in being able to select superior companies that will provide higher performance than the general market, then asset allocation is the only real option available to you to control your own destiny.

Don't reject asset allocation as something only very conservative people have to worry about, used aggressively it can boost returns substantially. For more info on this you can read up on asset allocation in the portfolios FAQ.

What are some typical portfolio asset allocations?

Many financial planners like to classify clients according to risk profiles, sorting them neatly into groups according to return requirements and risk tolerance. I don't use rigid risk profiles myself, I tend to tailor each portfolio, but this table shows asset allocations for portfolios which are fairly typical:

The easiest way to achieve the asset allocation that is right for you is to buy into a managed fund with the asset allocation closest to what you feel comfortable with, or to buy a bunch of funds in the right proportion for this mix.

Please note that these asset allocations are indicative only, you have quite a lot of flexibility to vary the asset allocation as you feel you should, but the general principle is that "high growth" investors want 100% of their money in shares and property, but more conservative investors mix in greater numbers of "defensive" assets, like bonds and cash, for the stability and the high income yields they provide.