What is asset allocation? The basics

Investing is full of jargon. One term you might have heard thrown around is ‘asset allocation’. But what does it mean - and why is it important?

While it sounds quite complex, it’s actually a fairly simple idea. All asset allocation really means is how you divide your money between different types of investments, otherwise known as asset classes.

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What are the different types of assets?

In the spirit of keeping things simple, let’s look at the main assets that you’re likely to come across.

These include:

• Shares - where you own a small part of a company.
• Bonds - where you effectively lend money to a company or government, usually in return for interest.
• Property - where you invest in property such as offices, warehouses or shopping centres, either directly or through an investment that owns them.
• Cash - money held as cash or in cash-like investments.
• Alternatives - investments that tend to sit outside traditional shares, bonds and cash, which can include infrastructure and commodities.

Your asset allocation is simply how much of your money you hold in each.

Have you ever heard of a 60/40 portfolio? All that means is the asset allocation of the portfolio. Imagine you have £10,000 invested. A 60/40 allocation would mean you hold £6,000 in shares and £4,000 in bonds.

• Read: 60/40 portfolio split explained: the basics

Why is asset allocation important?

Different types of investment behave differently in the same economic conditions.

Shares, for example, have historically offered greater potential for growth over the long term, but their value can also rise and fall more sharply. Bonds can behave differently from shares and are often used to help reduce the overall ups and downs of a portfolio.

Holding a mix means you’re not relying too heavily on any one type of investment.

Your asset allocation can therefore have a big influence on how much your portfolio rises and falls, as well as its potential to grow over time. In simple terms, it helps determine the balance between risk and potential return in your portfolio.

Generally, the more you hold in higher-risk investments such as shares, the more you should be prepared for the value of your portfolio to rise and fall. Holding more in bonds and cash may mean smaller swings but could also mean less potential for long-term growth.

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Asset allocation vs diversification: what’s the difference?

Asset allocation and diversification are closely related, but they’re not quite the same thing. Asset allocation is about the mix. Diversification is about the spread.

Once you’ve decided how much to invest in different asset types, you can spread those investments further across different countries, sectors and companies.

As the infographic shows, a diversified portfolio might hold different asset types, while also investing across countries such as the UK, US and emerging markets, and sectors such as technology, healthcare and finance.

The aim is to avoid having too much riding on one investment or one part of the market.

Diversification can help spread risk, but it can’t remove it altogether or guarantee returns.

Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. Direct shareholdings should generally form part of a well-diversified portfolio of other investments. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.