What is asset allocation?
When determining where to put your money, you need to consider diversification because the future is unknown and uncertain, so spreading your investments reasonably allows you to withstand the bumps in the road. You don’t need to overly diversify, but you want to spread your investments over different types of risks and asset classes.
Asset allocation is how investors divide their investment portfolio among different asset classes. Asset classes are a group of investments that share similar characteristics and are subject to the same laws and regulations. Common asset classes include equities, fixed-income, alternative investments and bonds. Investors aim to balance risks and rewards based on financial goals, risk tolerance, and the investment horizon, which is done through asset allocation. Here are our six principles of asset allocation.
1. Make sure you can stick with it no matter what happens
The first step of asset allocation – the strategic step – is finding an asset allocation breakdown that meets your individual needs. This means that you should end up with a breakdown and associated risk you can live with no matter what happens in the market; even in the case of an extreme shock triggering a temporary markdown of the portfolio. And remember: when markets are volatile, your strategic allocation is your default investment position, not cash.
2. Start with your investment objective to determine your risk tolerance
The first question you need to ask when building your asset allocation is ‘what is my investment objective’? Here, the most important step is defining your risk tolerance, as you will calibrate your asset mix based on the amount of risk you are willing to take, and this will reflect in your returns over time.
3. Adopt a forward-looking approach
Once you have defined your risk tolerance, you can begin allocating your assets. There are various ways to build an asset allocation, but the one approach I have rejected from very early on in my career is looking backwards. This method involves looking at past returns and correlations. However, given that the starting point is different, the returns will be different too, so this does not work. Critically, history shows that correlations are very unstable over time.
At Julius Baer, we prefer to take a forward-looking perspective. It starts with the Secular Outlook, where we carve out the key structural trends and forces that are at work in the economy and will impact the markets and investors over the next decade. We then make assumptions about how different assets will perform in that environment and reflect that in our strategic asset allocation.
4. Building blocks should be combined in a meaningful way
Once you have decided on your asset class breakdown, you need to decide how you are going to implement each and every asset class that makes up your portfolio. Will you invest passively or actively? For both active and passive investing, you have to pick the right instrument, and this is about making sense of the whole portfolio, because the sum of the parts is far more important than each and every individual part. Some common instruments include stocks, bonds, Exchange Traded Funds (ETFs) and pooled funds.
5. Longer time horizons work best, but be pragmatic
Time horizon is a big consideration. While every investing textbook will tell you that the longer the time horizon, the better, the matter is – life is uncertain. The paradox is that the longer you are patient, the less uncertain investing becomes. Of course, you cannot tell everyone that they need to wait for 20 years.
6. Adjust your portfolio based on market opportunities and strategic goals
When should you deviate from your strategy? Most of the time it is important to stay the course and stick to your strategy. Whether you should act and do something different will be a function of what is happening in the markets. There will often be opportunities along the way to either take some profits and reinvest some capital in other asset classes or to rebalance and buy more of what you already own, but it is really the markets that provide these opportunities over time.
There will also be times when volatility will be low and the dispersion of asset returns is rather low, so why would you move? But there will also be times when volatility is higher, providing opportunities to trade.
There are other circumstances when you may want to adjust your portfolio. Rebalancing is an important one, as it has the merit of bringing discipline and helps you stick to your investment goal. A good rule of thumb is to rebalance once a year, preferably not at year-end. You might also want to adjust your investment goal. The circumstances of individuals will change over their lifetime; their liabilities, their family, their personal situation will change.
Finally, you should fundamentally revisit your strategic allocation once a year. Again, I cannot emphasise enough how important the secular outlook is, as you need to understand the changing structural trends that affect asset prices and then position yourself accordingly.
Key takeaways: What to remember
The most important thing to remember is that while emotions will play a role, you should be able to stick to your asset allocation no matter what happens in the markets.
The second point is that while a forward-looking approach is better than a backward-looking one, you should not spend too much time predicting the future. You need to diversify precisely because the future is unknown and uncertain. Every once in a while, there will be an opportunity in the market, such as a big shock, when you can really take advantage of it. But most of the time, start from the principle that you don’t know what happens tomorrow and through diversification and strategic asset allocation your portfolio can withstand the ups and the downs.