Assuming that you are going to have exposure to all the main asset classes (shares, property, fixed interest and cash) you will need to figure out what proportion you will have of each. This is asset allocation, which is simply the percentage of each of the main asset classes that you have in a portfolio or fund.

This is the most critical decision that you will make for your investments (more than anything, it will dictate the returns that you get and the volatility that you will experience). Therefore, the first thing that any investor should do is establish the kind of investor they are and the asset allocation they should have. The main asset classes are growth and income.

Growth Assets

•          shares (a.k.a. equities)

•          listed property

Income assets:

•          fixed interest (a.k.a. bonds)

•          cash

Asset allocation is the percentage of each of these that we allocate to a fund and, to make things a bit simpler, we have descriptive terms for the funds or portfolios according to their asset allocation.

A Conservative fund would have an asset allocation like this:

•          shares 25%

•          listed property 5%

•          fixed interest 55%

•          cash 15%

This portfolio or fund would be said to have 30% in riskier growth assets (shares and listed property) and 70% in less risky income assets (fixed interest and cash).

A Balanced portfolio would look like this:

•          shares 40%

•          listed property 10%

•          fixed interest 40%

•          cash 10%

This is split 50/50 between growth and income assets.

A Growth portfolio would be:

•          shares 60%

•          listed property 10%

•          fixed interest 25%

•          cash 5%

This is split 70/30 between growth and income assets.

The above examples split both growth assets and income assets into two: into shares and listed property for growth assets, and fixed interest and cash for income assets. Each of these four main asset classes (shares, listed property, fixed interest and cash) can be split further. For example, shares can be split into international shares, New Zealand shares, emerging markets shares, etc. Fixed interest could be split into international fixed interest, New Zealand fixed interest, emerging markets fixed interest.

Although further splits into many more minor asset classes are common, the really big split to watch out for is between growth and income assets. You will commonly hear talk of a 30/70 portfolio or a 70/30 portfolio and it is this split that is most telling when it comes to risk and return.

Asset allocation is important — numerous studies have shown that the proportion you have of growth assets and income assets will dictate your investment performance (the returns that you get and the volatility risk you will experience) more than anything else. We could spend all of next week arguing about whether you should own shares in Contact Energy or Meridian Energy in a portfolio, but that is unlikely to make any real difference to a portfolio compared to your asset allocation.

This edited extract is from Cracking Open the Nest Egg by personal finance expert Martin Hawes. The book sets out to help people with the way they should invest when the nest egg has hatched, and how they draw down from their savings to give a good retirement. The book is available now where all good books are sold ($39.99 RRP, Upstart Press). Buy it here