Asset allocation: investing your assets in a structured way

What does asset allocation mean?

Assets are individual financial instruments or tangible assets in which you can invest. An asset could for example be a share, real estate or an artwork or collector’s item. In an investment context, assets which have a similar risk-return ratio are assigned to an asset class.

The most well-known asset classes are:

• Shares
• Bonds
• Real estate
• (Foreign) currencies
• Commodities

Asset allocation therefore refers to the systematic distribution of an investment portfolio to different asset classes. The aim is to optimize the portfolio so that risks and returns are balanced.

However, assets can also be distributed or allocated differently within these traditional or core asset classes. For example, they may be distributed across Swiss bonds, foreign bonds hedged against the Swiss franc and foreign bonds in the relevant currency.

For shares, distribution by geography and/or sector is most common. An example of this are funds with the “Swiss domestic market” focus, which form their own category within the share class. Asset classes can also differ based on market capitalization, namely large, mid and small caps.

Optimizing your investment portfolio: the role of diversification, asset allocation and correlation

Both asset allocation and diversification are important factors in shaping an investment strategy. While they influence each other, they have different meanings:

Asset allocation refers to splitting assets into different asset classes, such as real estate, shares or bonds. To do this is to take a diversified approach, that is to apply the core principle of diversification.

• Diversification is a core principle that is applied within asset allocation.
• Both concepts use the correlation between different assets to optimize the risk-return ratio.
• Diversification aims primarily at reducing risk.
• Asset allocation is focused on achieving an optimal risk-reward ratio.
• Both concepts are used to improve the overall performance of the portfolio.

The correlation between two assets can be between –1 and +1, where +1 indicates that two assets have moved in lockstep with one another, and –1 indicates they have moved in opposite directions. A correlation of 0 means they have moved completely independently of each other. The lower the correlation between two assets is, the more suitable they are for diversification.

Shares and gold are an example of this. When shares lose value in times of crisis, gold tends to rise in value because it is considered a secure currency. A negative correlation like as this would be advantageous for a balanced portfolio.

In an ideal scenario, individual investments should be well matched and should complement each other. Specifically, this means that they should respond differently to changing market conditions while still performing positively overall.

Strategic or tactical asset allocation?

Asset allocation is divided into strategic and tactical asset allocation.

Strategic asset allocation

Strategic asset allocation employs a long-term approach. The portfolio is assembled on the basis of determined weightings with only slight adjustments made.

A strategic asset allocation could for example be as follows, with up to a quarter made up of foreign currencies:

• 45 percent shares
• 35 percent bonds
• 10 percent money market
• 10 percent real estate

This distribution should remain in place for as long as possible to guarantee the performance of the portfolio in the long term. The aim is to have a portfolio with assets tailored to your long-term wishes and needs.

If stock prices then rise on the stock market, the equity component can be temporarily increased as part of a tactical asset allocation.

Tactical asset allocation

In contrast to strategic asset allocation, tactical or dynamic asset allocation enables short-term adjustment of the portfolio. Individual asset classes are temporarily overweighted or underweighted, depending on current market developments. This means you can benefit from short-term opportunities and possibly increase your total returns.

If, for example, the stock markets rise, the equity component could be increased in the short term to take advantage of the better potential returns. This approach comes with higher risk, as it aims at taking advantage of short-term market developments.

Both approaches can go well together. A strong strategic basis helps take advantage of new opportunities through targeted tactical adjustments.

The main approach chosen depends on the investment goal and your personal investment profile. More on this can be found in our article entitled “Put it simply, please! Investor profile”.

When is an adjustment needed?

The initial distribution to asset classes is not static. Price changes and the purchase or sale of securities may alter the make-up of your assets in ways you did not intend, which could lead to overweighting or underweighting of certain asset classes.

It is therefore important to monitor and regularly balance the portfolio not just in terms of diversification, but also in terms of weighting. To achieve this, you should reallocate your assets, resetting the share of each asset class to your preferred proportions.

However, it is not necessary to fix every deviation right away. In fact, a better, more efficient method is to readjust only after major changes, because a long-term perspective without constant adjustments will really pay off when it comes to compiling your personal portfolio.

What does optimal asset allocation look like?

There is no universal formula for optimal asset allocation. However, with targeted portfolio structuring, potential returns can be optimized and risks minimized.

The right weighting of individual asset classes for you depends on a number of individual and personal factors, such as:

• Your desired return
• Your risk appetite
• Your investment goal
• Your investment horizon
• Your required liquidity during the investment term

There are risks and opportunities in all chosen investment strategies.

It is therefore important to determine these factors in advance and get advice from experts if you need it. You can then choose the best strategy and distribution of assets on this basis.