I wanted to start this important explanation with a weighty quote from a recognised expert but in spite of checking multiple sources I could not find anything that was not either a platitude or so self evident as to be only amusing. Sadly, most quotes from famous investors are meaningless drivel, smug and based on how they got lucky. 
There are some published deeper insights from people who really saw everything, like John Maynard Keynes but they are not directly relevant here. JMK’s most acute observation was of course: ‘in the long run, we are all dead’.
What is Asset Allocation?
Basically we are going to talk about dividing money to be invested into different pots/pockets/compartments, or more officially “asset classes”. The objective is to diversify the consequences of taking risk. Generally people say that diversification lowers risk – but it doesn’t do that at all. That is because risk is outside of our control – if there is a stock market crash, house prices boom, Carrilion goes bust, Tesla sells 10 million cars and so on, there is nothing we can do about that, nor the asset valuation effects that follow. We can however plan for the possibilities and not hold all our money in Carillion shares, or bonds, or a buy to let portfolio. We sensibly plan to deal with the impact of risk, not to reduce it.
The idea of diversification is in fact completely intuitive to any human being.
If you are going on holiday for more than a few days, you will pack clothes that allow for what you expect the weather conditions to be in all the places you are going to visit, and maybe even the sort of social events you expect to attend. I do know a few men who might argue with that and would indeed assume that flip flops are ok for all events, weddings and funerals included, but that just indicates a very high risk tolerance! If you have guests to a dinner party, you probably have at home more beverage options than your favourite Prosecco or craft beer! As educated humans, we know how to diversify to allow for unexpected possibilities. So the basic idea is not going to be too difficult to grasp.
What assets are available?
Over the years there have grown up conventions about what makes assets different from each other and therefore how they should be classified. In this respect investment assets are just like natural species – there are very high level divisions based on obvious distinctions and then a tree-like set of branches and twigs. In the same way that sometimes biologists and naturalists argue about classifications, so do investment specialists.
In a capitalist system, conventional economics divide assets according to how they are used and paid for. Land (property) gets rent, Money (loan capital) gets interest and Risk Capital (shares or equities) gets dividends. Labour gets wages but one can’t directly invest in people’s working efforts these days. The main asset classifications follow this convention so are equities (shares), bonds (loan stocks issued by both public and private bodies), property (commercial in the main, but can be residential), and cash (deposits with banks and public institutions). In the modern world there are also many artificial derivative instruments which can be loosely called alternatives.
Slicing and dicing
Classic research into the use of different classes of investments to reduce the impact of losses and stabilise returns depends on the concept of correlation. That is the way in which the value of something varies when another factor varies. Now the details get a little bit more complex.
Think about this: the rise in temperature of water in a kettle is correlated with the number of joules of energy being pumped in by the heating element – a positive correlation actually so direct that it forms part of the laws of physics. One rises in direct proportion to the supply of the other. On the other hand, there is only a minute correlation between the increase in the water temperature and the temperature of the kitchen in which the boiling kettle is located. This is useful to know, as humans in the kitchen don’t want to find themselves boiling along with the water! Obviously the temperature in the kitchen may be more correlated with the setting on the thermostat on the heating radiator!
I know, because it is my birthplace, that a beach stall holder on Bournemouth beach also know a bit about correlation: she knows that there is negative correlation between sales of sun tan oil and rainy weather (if it rains a lot, sales don’t happen) and a positive correlation between sales of umbrellas and rainy weather. It follows that sales of sun tan oils and umbrellas will not tend to track the same pattern given any one period of settled weather.
If we think of the economic climate as the investor’s weather, then we would want to have sun tan oil and umbrella-like investments. Generally, history would suggest that might be shares (for hot times) and government bonds (for rainy days), but in the same way that the beach marketeer would like to have a rather wider of range of products to sell and deliver a profit in all climates, investors want to have other choices ideally with varying degrees of correlation.
To make this possible asset classes are sub divided and checks made to find variations in correlation. Shares are separated by country, industry sector, company size, dividend payouts and so on. Bonds are divided by currency, the level of interest being paid and the creditworthiness of the borrowers. Properties are divided between offices, shops and warehouses. And so on. Then one can look at what happened in the past and apply some statistical maths and get some idea of correlations and non-correlations.
In fact in the modern investing world, one can specify characteristics that you would like an asset to have and if your are wealthy enough, a merchant bank will create a derivative instrument to suit (with some risk attached, of course). So you could say: ‘I want to own a fund of shares in the Baltic states, with no more than 30 holdings, 10 in each of the 3 republics and no one shareholding to be more than 4% of the total)’ or ‘I want a security that will pay me back my investment plus 30% in 6 years time as long as the S&P 500 index does not fall more than 50%)’. These are genuinely realistic but very narrow assets that could exist.
Quite often, not having enough really wealthy customers wanting to pay them fees to make up esoteric assets on a private basis, merchant banks will invent what they think might be an attractive looking asset (with a good profit for themselves built in) and promote it as a ‘structured product’, exchange traded note or fund or similar and then market it to smaller investors as a portfolio component.
So, where do we start?
Several Nobel Prize winning theses have been written over a very long time period on the subject of efficient portfolio construction. So this article is not going to be able to propose a neat answer that will make you an investment guru. 
On the other hand, it is possible to make a good start.
Firstly, having dealt with the objectives, level of risk to be accepted, cash flow needs and tax considerations, draft a rough mix of simply higher and lower risk assets, for example 60/40, if you are cautious, need to take some income and will regret short term declines in value, or 90/10 if you don’t need this money for many years, will probably add to it and won’t really even notice short term market fluctuations. The only class at this stage is ‘high risk’ and ‘lower risk’ and there is no exactly correct answer. You can change your mind later, anyway.
Next, add asset types to the higher risk and the lower risk portions. Add things like equities and property funds to the higher risk part, then bonds and funds with risk control elements to the lower risk part, plus maybe some deposits. Adding specific funds (or shares if you are that way inclined) can come later. At this stage having some advice or doing your own further reading will be useful.
Let’s return to the example of Alex Bright to work this through. Remember that she had UK, European equity funds, a ‘managed’ fund (which would be almost all UK equities) and she added a US equity index tracker and a high yield bond fund. The chart below, courtesy of the Market Realist web site, reveals that High Yield bond funds are much more closely linked to shares when it comes to price changes than they are to something very defensive and cautious like US government loans (Treasuries) . So she had very little diversity. That was the wrong way to do it. She had roughly the right idea but a poor understanding of what assets she was actually getting.
So, what ought she to have done? At a high level, she wants to be able to take money out at short notice, so she should allocate maybe 3 years worth of potential withdrawals to low volatility assets. Lets make that 30%. The rest could be higher risk, but she is investing right at the top of a long bull market. So maybe it makes sense to hold some cash back for now. An asset mix of 50% equities (divided by country, style and theme), 30% low volatility bond and alternatives funds and a holding position of 20% cash would be an option. That second cash portion is on top of her spending reserves.
In the next article, I will explore how some funds could be added to this asset mix