Much is written about asset allocation, but many investors refuse to acknowledge its benefits, or feel their investment portfolio is too small to warrant applying what sounds like a lot of complicated mumbo jumbo.

However, the principle is quite straightforward. By and large, your assets will fall into one of four self-explanatory categories: equities/shares, fixed interest (i.e. bonds), property and cash. Depending on the point of the economic cycle, certain assets perform better than others.

Most research into investment performance shows that the best returns are not generated by the ability to pick the right shares, but the ability to allocate your capital to the right assets at the right time.

Equities still dominate

Over the past 100 years, equities have consistently outperformed all other asset classes, such as property or cash. According to The Global Investment Returns Yearbook (produced for ABN AMRO by the London Business School), an investment in UK equities of £100 at the start of 1900 would, with dividends reinvested, have grown to more than £2.1 million by the end of 2006, a return of 9.8 per cent per annum. Long bonds and treasury bills gave lower returns of 5.4 and five per cent per annum respectively, although they did beat inflation. However, £1 invested in a savings account over the same period would be worth just £184 if all the interest had been reinvested.

But perhaps the first question investors have to ask themselves relates not to which assets will perform well in the future, but to their attitude to risk. ‘We always ask a client what their primary objective for investing the capital is – capital growth or income?’ says Sheridan Admans, an investment adviser at The Share Centre. ‘Both objectives need very different asset allocation strategies. The other questions I’d ask are how long the investor’s investment time horizon is, their current age, when they intend to retire and whether they have any outstanding loans and liabilities. You should consider all your current liabilities ahead of any investment, so if you have debts, paying them off is a far better allocation of your capital than investing.’

Safety first

Admans adds, ‘We always recommend that a customer has access to a fund of money for financial emergencies and short-term planned expenses. This should be at least three times the customer’s monthly income. If this amount is not available, they should initially save it in cash deposits for easy access and security.’

Admans says there are no hard and fast rules to asset allocation models and that, when building a portfolio for customers, there is a balance to be struck between investors’ objectives and their attitude to risk. He says that the five example portfolios would be a starting point, but would change when an investor’s objectives and risk attitudes are factored in.

How great is your appetite for risk? Only you know. The approach taken by IFA Bestinvest when asking potential investors about their long-term strategy and risk tolerance is to frame the question in terms of how much the investor might be prepared to lose, with a tolerated loss of 30 per cent classifying them as ‘adventurous’.

‘We ask what the timescale is for their investment and if they have any income requirements,’ says John Spiers, managing director of Bestinvest. ‘Based on that, we can create a model portfolio with an appropriate split between equities and bonds in order to reduce volatility – and therefore risk.’

Alternatives to equities

As most What Investment readers are aware of the power of equity-based investments in creating wealth, let us first look at the three other slices of the asset allocation pie: fixed interest, property and cash.

Dealing with bonds first, John Chatfield-Roberts, lead manager of the Jupiter Merlin Portfolios, says, ‘At a time of rising interest rates, it has been a difficult environment for bond fund managers to generate positive capital returns,’ he says. ‘In contrast, cash offers a reasonable yield, with interest rates at 5.75 per cent, but no risk of capital erosion other than through inflation. While we have been using cash as a proxy for bonds, we also feel that, as equities have had a strong run, having some cash on deposit is a sensible strategy, in the event that buying opportunities emerge in the months to come. We are, after all, still positive on the longer-term outlook for equities.’

So what about cash? According to Andrew Merricks, head of investment at IFA Skerritts Consultants, too many of his clients keep too much long-term capital in cash. ‘We all need some cash,’ says Merricks. ‘However, as a long-term investment, numerous studies have shown it to be risky in its own right, as our old enemy inflation will eat into it steadily over the years. Having said that, as interest rates have risen recently, cash looks a lot more attractive than bonds and is much lower risk. Corporate bonds are a lot riskier than many people believe.’

Merricks agrees with Admans at The Share Centre and advises clients to keep three months’ income on deposit and use any cash to settle debts before venturing anywhere near the stock market: ‘We all need some liquidity in our finances, and that’s the role cash plays. But too much liquidity can be a bad thing.’

As can too much exposure to property. ‘If you own the roof over your head, in my book, that’s enough exposure to property,’ says Merricks. ‘Commercial property? That time has passed. When it fails to perform, the money moves out of the property funds and the asset managers impose penalties. We have seen it happen recently and, if there’s a fall in commercial property, investors could get trapped in these funds and have to pay high penalties.’

Back to the stock market

Which leaves equities. But after more than four years of rising equity markets, should investors be starting to grow more cautious? ‘Yes and no – it depends on your time horizon,’ says Jupiter’s John Chatfield-Roberts. ‘In the medium to longer term, we are happy to keep as much money as possible in equities. Compared to the other main asset classes, the case for equities is far stronger. With interest rates on the rise in many markets, it is hard to see any value in bonds.’

He adds, ‘Similarly, higher interest rates are starting to hurt residential property markets, notably in the US and Spain. In contrast, companies are still growing their profits well and are holding high cash balances. At the same time, equity markets are not expensive in historical terms.’

Chatfield-Roberts says the Merlin portfolios have been building up cash for the shorter term, both as an alternative to bonds and to sustain the yield for the Merlin income portfolios. But he maintains, ‘Whatever the market throws at us in the short term, we still think that equity markets are the right place to be invested for the long term,’ he says.

When it comes to investors and their portfolios of investment funds, Merricks sounds a final note of caution. ‘If allocating your capital to assets, you need to make sure that capital within a particular asset group is diversified, particularly with investment funds. I see so many clients who have a collection of funds they think are diversified but suffer from what I call ‘stockoverlapitis’. They have three or four UK funds, but each of these funds has a big weighting in the large blue-chips.’

He concludes, ‘Before you add a new fund to your portfolio, check and make sure your existing funds don’t already overlap with the new fund. There is no point getting the asset allocation right only to come unstuck through lack of diversification.’

This article is from the October 2007 issue of What Investment.