Asset allocation: the nuts and bolts of your investment

In the last article, you learned about the positive effects of smart diversification when investing. In this article, we want to take this topic a step further and focus on asset allocation: the key success factor for your investment! In this article, you will find out how to structure your assets according to your needs and risk profile.

Determining your risk profile

Asset allocation depends on your individual risk profile. This in turn is influenced by the following three factors:

• Investment horizon
• Willingness to take risks
• Risk capacity

Investment horizon

Basically, the longer your investment horizon, the riskier and therefore more profitable you can invest your money. This is because, as we have already shown in this article, price fluctuations and stock market corrections can generally be better balanced out with longer-term investments. You also benefit from the powerful compound interest effect with a long investment horizon.

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Willingness to take risks

It is also important that you are aware of how much risk you want to take. Even the broadly diversified MSCI World share index with around 1600 shares lost over 57% (= maximum drawdown) in value in the course of the so-called subprime crisis between October 31, 2007 and March 9, 2009 (see MSCI World factsheet).

If you can still sleep peacefully (and don’t sell) even with such heavy price losses, you are clearly the risk-taking investor. But perhaps you are more risk-averse and your primary aim is to preserve the value of your investment.

Risk capacity

Risk capacity expresses the fluctuations in value and losses you can cope with without getting into financial difficulties. The less you are dependent on the invested capital to meet your obligations, the greater your risk capacity.

To clarify: a well-off childless dual-earner couple generally has a much higher risk capacity than, for example, a single mother.

How you can determine your asset allocation

Let’s assume that you have fictitious assets of CHF 100,000, which are interest-free and available at all times in your private account. We also assume that you have a regular income and that you have your running costs under control. Finally, you are not planning any major purchases for the next 10 years, such as buying a home.

Based on Markowitz’s scientifically oriented portfolio model (see also this article), we recommend first dividing the CHF 100,000 into a low-risk and a high-risk portion based on your risk profile (see Figure 1).

Important: No matter what type of risk you are, within the “low-risk” and “high-risk” investment categories mentioned above, the composition of the investments is basically the same.

“You can’t avoid equities in the risky part.”

Figure 2 shows an example of a broadly diversified global portfolio for the risk-averse or yield-oriented investor with a long investment horizon.

In the risky part, you cannot avoid equities. ETFs, which track broad market indices from all regions of the world, are very suitable investment vehicles. You can find out why we consider ETFs to be particularly attractive when investing in a separate article.

For an even broader diversification or a more advantageous risk/return ratio, real estate as an additional asset class is an interesting option. But here too, instead of taking on unnecessary bulk risk with individual securities or even individual properties (“concrete money”), it is better to invest in an ETF that contains numerous real estate companies or real estate investment trusts (REITs) worldwide.

In the low-risk part, on the other hand, your money will primarily be in your private account, which you can access at any time. We do not consider bonds to be an interesting option in times of historically low interest rates.

“Defining your individual asset allocation tailored to your risk profile is the be-all and end-all of your investment.”

Conclusion

Determining your individual asset allocation tailored to your risk profile is the be-all and end-all for a successful investment.

Based on your risk profile, your assets are first divided into a “high-risk” and “low-risk” part. The individual asset classes are then weighted.

The high-risk portion corresponds to a broadly diversified global portfolio consisting of the asset classes “equities” and, for example, “real estate”.

The investment vehicle“ETF” (exchange-traded fund) is particularly suitable for these asset classes.

The low-risk portion essentially corresponds to bank balances (“private account” investment vehicle).

In the next article, we will look at the topic of “rebalancing” and the question of how you can easily and cost-effectively restore your original asset allocation if the individual asset classes perform differently.

You can get a complete overview of the topic of “Investing” here: Learning to invest – in eight lessons.

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Disclaimer

Disclaimer: Investing involves risks of loss. You must decide for yourself whether you want to bear these risks or not.

Errors excepted: We have written this article to the best of our knowledge and belief. Our aim is to provide you as a private investor with the most objective and meaningful financial information possible. However, should we have made any errors, forgotten important aspects and/or no longer have up-to-date information, we would be grateful if you could let us know.