Some people’s idea of investment is betting all their savings on the 2.30 at Haydock Park. But as any responsible financial adviser would tell you, the first lesson of wealth management is that you diversify your risk, that is, you don’t put all your eggs in one basket.

A good wealth manager will ensure that an investor achieves a blend of different types of asset in his or her portfolio. This will typically include, at the very minimum, a mixture of shares, bonds, commercial property and cash. Some wealth managers will throw in other asset classes such as private equity, gold and commodities.

Dan Looney, of Towry Law, the wealth manager, says: “The point of having this wide spread of different investments is designed to achieve a balancing act or, in the technical jargon, a mixture of non-correlated asset classes. In other words, while shares may be going down another asset, such as bonds or commercial property, will be going up. The aim is to ensure that whatever happens to one particular part of your portfolio there will be another part that is sufficiently buoyant to prevent the whole portfolio being dragged down.”

This process of dividing your portfolio into different sections, known as asset allocation, is especially important because no one can forecast with any accuracy what will happen to shares, property, or any other asset. For example, few people called the top of the previous bull market in 2000 and even fewer accurately called the bottom of the bear market in 2003. Right now no one is certain what is going to happen to UK residential property over the next couple of years. Given investors’ inability to forecast the future, asset allocation begins to look like a very sensible bet. Financial experts have calculated that asset allocation makes up more than 90 per cent of an investor’s return

It is also a good way of avoiding the potentially disastrous trap of buying whatever is the prevailing fashionable asset. By opting for a diversified portfolio investors would not have found themselves with a basket of technology funds in 2000, or a pile of commercial property funds in 2007.

Wealth managers will draw up different portfolios for different levels of risk. A cautious investor might have a portfolio with a heavier concentration of cash, bonds and property, while an out and out risk taker would have more in assets such as emerging market stocks.

Here, too, the balancing effect of a diversified portfolio has its role to play. For example, even cautious investors can benefit from having some shares in their portfolio, while very aggressive share investors should still hold some cash for liquidity and could benefit from widening their portfolio to include bonds and property.

Many investment houses start with a basic framework of three or four portfolios, ranging from low risk through medium risk to high risk and will then add on extra elements to suit the individual investor. Some use computer programmes to simulate millions of different financial outcomes in order to determine the best mix of assets for a particular individual.

One thing that managers try to do is to blend non-correlated assets together to produce a more “smoothed” performance. For example, a holding of US shares might be balanced by some Japanese shares, which do not tend to move in the same pattern as US shares. In the same way a holding in UK shares might be balanced by one in residential property, which is non-correlated with the stock market.

When putting together their portfolios wealth managers usually break down the traditional asset classes into many different sub-groups. For example, shares will be broken down geographically into UK, Europe, US, Japan and emerging markets, and also by sector size, such as large caps, mid caps and small caps. In this way, managers can achieve additional fine tuning of their portfolios.

The ultimate aim of all these approaches is to construct a portfolio that will provide the maximum level of return for a stated level of risk, or offer the minimum level of risk for a given expected return.

Dan Looney, of Towry Law, says: “Sensible diversification of assets may not sound particularly exciting and performance is unlikely to shoot the lights out, but it should deliver more consistent investment returns and enable investors to sleep more easily at night.”

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