Beating the enemy of inflation

To do this, the value of your investment portfolio has to grow by more than the change in the cost of living - it has to grow faster than inflation. Inflation is your number one enemy. Even with 2% inflation, you will need nearly £150 in twenty years time to buy the same amount of stuff that £100 buys today.

It would be nice if you could achieve this goal by just put your money in a savings account every month and forget about it. A prolonged bull market in shares would also be helpful. But in a world of low interest rates, fairly high share prices and uncertainty about future economic growth, meeting your goal is probably going to be quite tough.

To get there you are probably going to have to take some risks with your money.

Sticking your money in a building society account or buying lots of government bonds is not going to get you very far given the current interest rates on offer. You might be alright if you are able to save lots of money.

This is why lots of people have turned to the stock market in recent years. It's one of the few places where there's a chance of getting a decent return on your money.

What do we mean by risk?

To most people investment risk is about losing money. That's how I see it too.

But for me the risk is not having enough money when I need it. It's about losing money forever without any chance of getting it back. For someone saving for retirement that risk might be in 10, 20 or 30 years' time, not the value of your portfolio today.

The regular ups and downs of the stock market which change the value of your portfolio is known as volatility. Volatility is not the same as the risk of losing money or falling short of your goal.

Volatility measures how much the value of your savings pot moves up and down over a period of time. It is measured by calculating the standard deviation of returns which tells you how far they have moved from their average values. The bigger the standard deviation, the more volatile an investment has been. Shares tend to be very volatile investments.

Big gains in share prices make us feel good, but big falls - especially ones that occur just before we need our money - can be disastrous. High levels of volatility can also play havoc with our emotions which makes it more likely for us to make mistakes such as chasing things that have already gone up a lot and selling things that have gone down - a proven way to investment mediocrity or worse.

Over a long period of investing - say 20 or 30 years - volatility becomes less of an issue. That's because there is more time for good years in the stock market to offset bad years. The closer you are to needing your money - such as retirement - the more attention you need to pay to the potential volatility of your investments.

This is why people tend to shift their money out of volatile shares into less volatile investments such as bonds as they get nearer to retirement. This makes sense as you don't have enough time to recover from a big fall in the value of shares just before retirement

If you don't like the ups and downs that come with stock market investing there is something you can do about it. There is a way to get reasonable investment results whilst keeping volatility manageable. It's called asset allocation and is arguably one of the most important lessons an investor can learn - especially if you like to sleep well at night.

How asset allocation works

In the table below, you can see the average returns and volatility for UK shares, UK gilts, cash and gold between 1983 and 2015. Asset allocation is all about trying to match your investment goals (the required returns from your portfolio) against how much volatility you want to put up with.

Average annual investment returns and volatility 1983-2015

Source: Barclays Equity Gilt Study, Goldprice.org, FTSE, iShares.

Good year and bad year refers to the range of expected returns 2/3rds of the time or one standard deviation.

Bear in mind that what has happened in the past won't necessarily be the same as what happens in the future.

Historically you have received higher returns from shares but they have been more volatile (their returns have had higher standard deviation and bounce around more). Government bonds and cash have produced lower returns but with a less volatility. Gold - a supposed hedge against really bad things happening - has given low returns but with lots of volatility. In fact, since 1983, gold has been more volatile than shares and has made less money than cash in the bank.

The returns and volatility from different periods are shown in the table below

Over time shares and gold have been consistently more volatile than cash and bonds.

Asset allocation in practice - Harry Browne's Permanent Portfolio

One of the simplest examples of an asset allocation strategy is an approach developed by US financial advisor Harry Browne in the 1970s.

After living through the terrible investment markets of the 1970s, Browne set about devising a strategy that was intended to be simple, safe and stable. He wanted to put together a portfolio that could cope with most of the things that the world could throw at it - recessions, inflation, deflation - as well as making reasonable money when times were good.

What he came up with was a very simple portfolio which was invested in the following way:

• 25% in US stocks
• 25% in US Treasury bonds
• 25% in cash
• 25% in gold

Browne believed that investing in just these four assets would help most investors achieve their goals with a lot less worry. He reckoned that an event that damaged one part of the portfolio would be good for one or more of the other parts of it. Also, because each investment only accounted for 25% of the total portfolio, anything bad that happened to one part of it would not devastate the whole plan.

This portfolio became known as "the permanent portfolio". Browne wrote about it in a book called Fail-Safe Investing: Lifelong Financial Security in 30 minutes.

According to Browne, an investment in shares would provide good returns when times were good. Bonds also tend to do reasonably well when the economy is calm and growing steadily. Recessions or periods of deflation (falling prices) were bad for shares but good for high quality bonds and cash because the buying power of these investments increased. Periods of high inflation, whilst being bad for bonds, were good for gold.

Not only was the portfolio simple in theory it was also simple to run too. At the start of every year the investor would start off with their portfolio spread equally across the four different investments. At the end of the year, the portfolio would be rebalanced back to equal weightings (25% in each investment).

Annual rebalancing is the closest thing to a free lunch in investing. By doing this it means that you automatically sell a bit of the investments that have gone up and reinvest the money back into the ones that have done less well. So you are selling high and buying low whereas many investors do the exact opposite. Studies show that rebalancing is a good way to boost the returns of your portfolio whilst reducing risks at the same time.

This approach is quite simple but does it work?

According to authors Craig Rowland and JM Lawson in their book about Browne's permanent portfolio, between 1972 and 2011 a portfolio like this, rebalanced annually, delivered annual returns of 9.5% compared to 8.8% from the one that was left alone. It also increased the buying power of your money by generating annual returns 4.9% more than inflation.

That might not seem much. But over 39 years, the rebalanced portfolio only lost money in four years with a biggest annual loss of 4.9%. The other portfolio lost money in eleven years with a biggest loss of 21.6% - which portfolio would you rather own?

Practical issues with asset allocation in today's markets

Spreading your money around can certainly reduce the swings in value that your portfolio might experience. However, having large chunks of money in cash and government bonds might make for a good night's sleep but could make it very difficult to build up a sizeable retirement pot.

With cash and government bonds paying next to no interest does it really make sense to have half your money invested in them as Harry Browne suggested? Having a quarter of your money invested in gold is also questionable. It pays no income and has been a more volatile asset than shares in the past without the rewards.

There's no doubt that investors today face a very hard time earning acceptable returns from their portfolio without taking lots of risk with their money. That said the growth in exchange traded fund (ETF) products have also given them lots of choice for investing in different assets and building their own low cost DIY asset allocation plan. You can research a vast range of ETFs and investment funds in SharePad.

For example, a cautious investor investing for at least ten years could consider the following strategy that could give them a reasonable chance of meeting their savings goal without staking everything on the fortunes of the stock market. It would give them exposure to a range of investments that should behave differently to each other in some way and reduce volatility.

• 50% invested in dividend-paying blue chip shares with a minimum yield of 3%. Remember to reinvest your dividends
• 10% invested in a corporate bond ETF
• 10% invested in a commercial property ETF. A fund that invests in real estate investment trusts or REITS
• 10% in a UK government bond ETF
• 10% in gold ETF
• 10% in cash

The portfolio should be rebalanced from time to time (not too often to keep the trading cost down) if the size of investments stray too far from their target allocations. So if your shares perform really well and become 60% of your portfolio you might sell to get back to 50% and reinvest the spare money back into the other assets you have chosen.

Here a keen private investor would still be able to enjoy managing their own share portfolio whilst spreading the risk around. As will all parts of DIY investing you are in charge and can decide where to invest your money in a way that suits you. You can make it as simple or as complicated as you wish to.

To sum up

• Putting all your money in shares can be quite risky and is not suitable for all investors.
• There is a risk that shares might fall in value at the wrong time in your savings plan. You might not have enough time to make the money back.
• Volatility can make investors nervous and lead them to make mistakes.
• Spreading your money around in different assets can make the value of your portfolio more stable.
• Asset allocation is all about meeting your savings targets and controlling risk. You need to find the right mix of investments that can earn enough money without you worrying too much.
• You can take too little risk and fall short of your savings goal.
• ETFs have made it a lot easier to build a DIY asset allocation plan.
• A higher proportion invested in shares might work well for long-term savings plans as there is enough time for good years to offset bad years in the stock market.