Investing in the stock market offers potentially unlimited returns – a company could, in theory, grow from two men in a Californian garage to the next Apple – but could also leave you with nothing if the company goes bust.
Spreading your investments across a range of companies, asset classes, and regions will help to insulate your portfolio against the shockwaves that can hit a single area.
Diversifying into bonds, property and cash offers investors the chance to limit their potential losses at the expense of potential gains.
AWD Chase de Vere’s Patrick Connolly said: "The starting point is not to put all your eggs in one basket – don’t put all your money in one area, as if it falls then everything falls together, so you need to spread the risk by investing in different asset classes."
"What you are looking for in your investments are those that do not move up and down at the same time. You want some to be going up while others are going down, and over the long run they will all rise together."
Shaun Port, chief investment officer at Nutmeg, points out that the benefits of good asset allocation are not only to protect against downside risk.
"The studies vary in the percentage but show that 50 to 90 per cent of returns are generated from asset allocation," he said.
"Often being in the right market is better than having a manager who outperforms by 1 or 2 per cent."
What this means is that the different asset classes, generally speaking, do not move up or down at the same time, so that if investors can predict the moment that, for example, the stock market will fall and the value of government bonds will rise, they can sell stocks and buy bonds and make a lot of money.
In particular, they can make more money than by picking the right companies within their equity holdings or the right bonds within their fixed-interest investments, meaning that getting the right mix in your portfolio could be the most important decision you make.
However, when it comes to investing your hard-earned cash, the negative side is the first thing to consider – how much can you afford to lose?
"Before you put any money in risky assets you should make sure you have some money in cash in case something happens and you have a sudden need for it," Connolly continued.
Once you have your cash squirreled away, the next step is to decide on your objectives and time frame. If you are prepared to wait longer and to take on more risk, you will tend to have a higher exposure to equities.
If you want to reduce the risk of losing your money, the majority of investors will raise their exposure to cash, bonds and perhaps property. Income-seeking investors will be more attracted to the latter two classes because of the interest they pay.
Investors change their positions – moving into and out of asset classes – in accordance with their view of the wider economic environment, which FE Alpha Manager Philip Saunders, head of global asset allocation at Investec, says can lead to the temptation to make short-term decisions that can backfire.
"Placing too much emphasis on upcoming macroeconomic events and consequently too little on underlying fundamentals, such as valuations, is probably the most reliable way for investors to destroy value," he commented.
Saunders explains that in 2012 there have been huge macroeconomic worries, such as those over the eurozone and disappointing growth in China, that have led many investors to be cautious and put their money in lower-risk investments such as bonds.
However, global stock markets have actually done well, meaning those investors who were not swayed by the concerns have done better than those who were over-cautious.
Data from FE Analytics shows that the UK and US stock markets, and even the Euro Stoxx 50 index of the top European companies, have increased in value by more than 10 per cent this year, meaning an investor who had £10,000 in those markets in January would now have more than £11,000.
Performance of indices in 2012
Source: FE Analytics
Connolly agrees that obsessing about bad economic news in the headlines can lead to your downfall.
"A common mistake is moving your investment due to short-term performance and sentiment, and the result is people will buy at the top and sell at the bottom when everybody is nervous," he continued.
"There’s always something happening, there’s always something on the horizon, different asset classes will react in anticipation. The right approach for the vast majority of people is to have a long-term asset allocation strategy."
One macroeconomic event that has gained attention this year has been the US election and the worries about the implications for investors.
Saunders says people should not be worried by the hype.
"We suspect that markets are already responding positively to evidence that underlying economic conditions in the United States are improving and the degree to which either candidate can practically affect this as president is limited," he said.
Saunders explains that on his portfolios he decides on the asset allocation strategy for the next three to seven years, and then adds to this with shorter-term tactical changes on a three- to nine-month horizon.
One way of ensuring that you are not influenced by short-term concerns is to pick a multi-asset manager who can make the decisions for you – although this obviously depends on the manager himself being able to avoid short-termism.
Investors can buy multi-asset funds run by a single manager, or multi-manager funds that buy different funds that invest in different asset classes; both options leave the asset allocation decisions to the professionals.
Saunders said: "The primary benefit is access to professional asset allocation capabilities. Investors are confronted with an overwhelming range of investment options and the selection of the right ones, in terms of quality, likely characteristics, cost and timeliness is challenging at the best of times."
He adds that professional managers also have the ability and knowledge to use more complicated assets such as derivatives, which are beyond the understanding of most retail investors.
Connolly is less positive about this option, however.
"Multi-asset funds and multi-manager funds are good for the lower-value clients or those who don’t want to be constantly checking their investments but would rather hand the responsibility to a manager," he said.
The first downside, he explains, is that they are sold as "one-stop shops", meaning they are not tailored for your individual needs but intended for a wide variety of clients.
The second is the cost of multi-manager funds. The fees can rise to more than 2 per cent, as the multi-manager passes on to investors the charges of the underlying funds he has bought and then adds on his own fee.
How should I allocate my money?
Different assets have different risk profiles, and your portfolio should reflect a compromise between your willingness to take on risk and your desire to avoid losing your money.
If you have a lower appetite for risk you should be looking to limit the equities you hold.
Your aim should be to avoid a portfolio of correlated assets. If you aren’t sure how to construct one then you should consider taking advice.
A multi-asset or multi-manager fund offers a simple alternative that is particularly appealing to those who don’t have a large amount of money or who don’t want to have to think about when to switch between assets.