The show so far

In 'Simple Investing' we encouraged you to:-

• Understand the need to take some risk;

• Control that risk by finding a suitable (for you) balance between cash and shares;

• Spread that risk by diversifying.

In 'More Diversification' we introduced correlation and the principles of diversifying among shares. Now we ask: can we benefit by diversifying among asset classes - expanding our potential list of assets from the two classes of cash and shares?

This process is called 'asset allocation'.

Adding assets

We list ten asset classes in this site. These are cash, shares, bonds, index-linked bonds, premium bonds, buy-to-let, property, commodities, collectables and crypto. You may be quite happy to stay with the cash/shares mix you have found. Or you may want to try adding a third asset class.

There is nothing magic about the process now. You have to decide how much of your preferred third class to buy and what proportion of cash and shares to replace in your portfolio.

You will be guided by the consequential changes in expected return (probably a reduction) and your consideration whether it is justified by reduced risk.

You should end up with a new portfolio you are comfortable with, and maybe a bit of extra diversification. Against that you have the complication of managing a third asset class.

Adding a bit of science

You may be thinking all this is a bit ad hoc and there ought to be a scientific way of doing all this. and there is. It is called Portfolio Theory.

In More Diversification we mentioned 'correlation coefficients'. If you run all these numbers through a computer and tell the computer what level of risk (meaning ‘volatility’) you are comfortable with, the computer will spit out an investment portfolio (or a family of portfolios) that will give you the highest return you can get for that level of risk. These are called efficient portfolios.

Which raises the question....

• why don't we entrust our money to a Fund that has the expertise to find the efficient portfolios for us, and/or,

• why don't we use the information provided by fund groups, who may, for example, advise us that their computers show that 5% in some alternative asset class added to a standard portfolio will both increase return and reduce risk - the holy grail?

We spend time on this because these are extremely persuasive sales pitches and you need to understand why you might resist them.

...and the answer is.....

There are a number of of contrary factors:-

• Garbage In, Garbage Out applies. There is a correlation coefficient for every pair of assets in the model. With 10 assets, that's 45 coefficients. That's 45 forecasts of how two assets are going to relate to each other in their future performance. You might think that if someone is clever enough to get that right it would be easier just to forecast future returns and pick the highest.

• The maths assumes that correlation coefficients are fixed over time. There is no reason why that should be . In fact there is now some evidence that correlations increase in bear markets - in other words, diversification benefits break down just when you need them.

• There's a management trap called 'Managing to a Model' and you are in danger of falling into it. Portfolio Theory constructs a model of the investment problem and optimises it. The results provide insight; but they don't provide answers. It's only a model - a simplification. It uses just one definition of risk, for example.

• As always, you have to consider the cost of taking advantage of a perceived benefit. Does the improvement generated by modelling exceed the increase in your wealth management costs?

Do it with shares

You can get quite close to some asset classes by buying shares. If you want some exposure to property, buy property shares. If you want some exposure to commodities, buy mining shares. If you want some exposure to corporate bonds, buy gilts spiced with a few equities.

Other ways of slicing the cake

A reminder to finish with. It is easy to get hung up with asset classes. You can slice up the whole universe of investible assets in any way you like. Every way gives you a different angle for looking at things, a different set of decisions and, if you are not careful, another way of persuading you to lose the wood for the trees.

Stay with first principles - you need to invest in a range of different stuff, but the benefits of diversification fall quite quickly, and the complications increase, as you add more stuff.

What do we do now?

Get some specific, unbiased, personal advice - if you can find it.