Your financial survival could depend on how you split your assets

Your best bet at preserving capital and achieving growth in the months ahead is sensible asset allocation, says Bengt Saelesnminde. Here's how.

Your best bet at preserving capital and achieving growth in the months ahead is sensible asset allocation.

I've been saying that for a while and it's struck a chord. Readers have been asking me to elaborate on my suggested asset allocation: 25% equities; 25% cash; 25% bonds; and 25% commodities.

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They want to know my reasoning behind those figures. And it's a good question.

Of course, these things are always subject to change. But that is roughly what I'd advocate for present market conditions. Today I'll show you why.

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We'll also take a look at a common and dangerous misconception about asset allocation.

Don't fall for this out-of-touch asset allocation model

I guess you've seen a table like this before. They're often presented by financial advisors and the like. They're supposed to help you decide what sort of portfolio is best for you, depending on age and risk profile.

 Low riskMedium riskHigh risk
Equities30%50%70%
Bonds45%30%15%
Cash 15%10%5%
Commodities10%10%10%
 100%100%100%

The idea is that, the older you get, the lower risk you'll opt for. And that makes sense. The closer you get to drawing down on your assets, the less you want to take on the risk of a market crash.

So at that stage you go for 'low risk' bonds instead of equities, and a good slug of cash too. And if you're young and just hate risk you may opt for that sort of portfolio too.

Young and risk-hungry investors are advised to fill up on equities and leave cash and bonds on the sidelines.

But this is a crazy and lazy way to think about asset allocation. It's built on a template that made sense for much of the post-war period. But to my mind, today's investor faces different risks that need to be reflected in the asset allocation.

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It's that old inflation/deflation problem again

What if inflation comes knocking on the door? Inflation can rip the heart out of bonds. Even without inflation (as many European banks are finding out), bonds are subject to credit risks. Sovereign bonds aren't what they used to be.

And frankly cash, supposedly the safest investment of all, could be far from safe if we suffer severe inflation. Yet the 'safe' option in the table above fills up on bonds and cash.

But then look at commodities most fund managers aren't interested at all. Sure, over the last ten years or so, prices have been on a hair-raising rollercoaster ride and could be considered risky. But in an inflationary collapse commodities could be exactly what you're looking for. Yet most investors don't benefit from this diversification. They just don't know about it.

Now don't get me wrong. I'm not saying we're heading for an inflationary collapse. In fact there are many reasons to suspect a deflationary collapse. That's why you want to be covered for both eventualities. Perhaps a Tesco bond yielding 5% doesn't send your heart racing today. But I can assure you, if we head into a long spell of Japanese-style deflation, you'll be feeling rather smug about a nice little 5% coupon year-in-year out.

I don't mention deflation/inflation risks lightly, by the way. They are very real concerns that I and many Right Side readers share.

If you consider that your retirement savings may not be drawn down for 20, or 30 years, then you'll probably agree that we could experience both 'flations along the way.

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That's why we need to keep an open mind on asset allocation. We need to diversify against many more risks than simply a stock market crash.

So here's my general plan. This is just an overview. I'm currently writing a more detailed analysis for how I split my assets within the following four asset classes.

Today, let's start with the overview

Cash 25%

During the last few years we've witnessed an extraordinary period of volatility. The battles are raging: inflation vs deflation, paper vs real assets, and, of course, investors vs speculators.

Opportunities regularly show up amongst the debris of battle. And they'll continue to do so. The way to take advantage of an opportunity is to have some cash at hand. In the past, it's been easy enough to flip from one asset class to another. But today, the markets tend to move in unison. Market dislocations tend to push all investments in the same direction. That's why we need a healthy slug of cash in the portfolio. It's always there our reserve troops.

Sure it's not paying much interest that's the price you pay!

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Equities 25%

At 25%, my equity allocation is lower than it's ever been. And it's invested in more defensive stocks than ever too. That reflects my views about risk in the markets right now.

Equities are for optimists they offer practically zero security. But given that they offer ownership of the business, there's some tangible safety here. And seeing as I'm an optimist at heart, no matter how grim things look, I'll always want some carefully selected equities.

Equities also offer some inflation protection. And note that I said 'some'. Businesses that can increase their revenues in an inflationary environment are worth having. I'm thinking about utility providers, supermarkets, insurers and the like.

Mostly, I want high-yielders with a big defensive moat. And, of course, the occasional out-and-out speculation, if I see something I fancy.

Bonds 25%

I've been more attracted to bonds over the last few years. And I'm not alone. Data out this week from Blackrock says that investors have been moving out of equity ETFs and heavily into bond ETFs over recent months.

In many ways I like the idea of leaving equity holders with the thick end of the risk, while I take the stable cash returns. Recently I've mentioned bonds from Legal & General and Enterprise Inns that offer enticing returns. In a low interest rate environment, you've got to take what you can get.

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As well as the more risky high-yield bonds, you can find bonds from more stable sources too. The likes of BT, National Grid, Tesco and Vodafone all offer bonds that can be bought and sold through a regular stockbroker.

In the New Year I'll continue to update you on what I see as the best opportunities. For now, if you need an introduction to bonds, read this.

Commodities 25%

Commodities are my main inflation hedge. They're also a play on growing global demand. I suspect the next twenty or thirty years are going to be defined by a battle for resources. I'm an advocate of the commodities super-cycle, so I want to be in the thick of it.

I include precious metals in this allocation. I think I've made my feelings on this pretty clear over the last year! Physical gold is my insurance policy against the whim of politicians. I'm holding on to it as tightly as I can!

So that's my rather hurried waltz through why I've split my assets rather neatly into four classes.

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