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Created on 30.04.2019

Asset allocation: how to structure your assets

For investors, the question of how personal investments should be structured is crucial. As such, knowing how asset allocation and diversification differ and how they are interconnected is key to ensuring financial well-being in the future. It is possible for investors to strongly diversify their investments, but have poor asset allocation at the same time. In this article, you will find out what you need to bear in mind when investing.

Generally speaking, asset allocation refers to the distribution of assets across different asset classes. Well-known classes include shares, bonds, currencies or even alternative assets such as raw materials and real estate. But assets can also be distributed within these traditional or core asset classes. For instance, they may be distributed across Swiss bonds, foreign bonds hedged against the Swiss franc or foreign bonds in the relevant currency. In other words, the possibilities are endless. The purpose of selectively distributing the assets in a portfolio is to optimize their return and to reduce the risk.

Asset allocation refers to distributing a securities custody account across various asset classes such as shares, bonds, currencies or even alternative assets. There are two types of asset allocation: strategic asset allocation, which is designed for the long term, and tactical asset allocation, which is geared towards the short term.

Strategic vs tactical asset allocation

In the process of structuring a portfolio, investors must choose between strategic (long-term) and tactical (short-term) asset allocation. The strategy determines how assets are distributed in the long term, based on the personal investor profile (find out more in the article “Put it simply, please! Investment profile”). Strategic asset allocation (SAA) is guided by an individual’s risk capacity and appetite, as well as their investment horizon. The strategy determines and weights each asset class within the portfolio, and it also establishes the size of the holdings in local and foreign currencies. This means that strategic asset allocation could result in a portfolio that is distributed as follows: 45% shares, 35% bonds, 10% money market and 10% real estate, with foreign currency holdings of 25%. Depending on market trends, the effective equity component could well increase to 55%. If you choose tactical asset allocation, you decide whether you wish to continue overweighting your shares, or if you wish to sell 10% of your shares and invest in other asset classes. You can make the same decision about your currency split, too: for example, political decisions or economic events might make it a good idea to underweight the euro or to overweight the US dollar.

Diversification is essential to successful investment

Diversification should always be considered when structuring a portfolio. Read about how exactly this works in the article “Diversification explained”. Diversification is essential insofar as the risk you are taking is heavily determined by the relationships between individual investments. That is why it is important to take correlation into account when compiling your portfolio. The term “correlation” refers to the strength of the relationship between the returns on different assets.  Correlation may 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 there is no relation between how they have performed. The lower the correlation between two assets is, the more suitable they are for diversification. For example, a negative correlation between shares and bonds is perfect for a balanced portfolio. A fall in share prices could also be compensated by the bonds to some degree.

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 whilst still performing positively overall.

Over- or underweighting

Faced with an ever changing environment, it is vital not only to optimize how you diversify, but also to keep a close eye on your portfolio and to ensure on a regular basis that it is balanced. 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 over- or underweighting of certain asset classes. To combat 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 re-adjust only after major changes.

This long-term perspective will really pay off when it comes to compiling your personal portfolio. If you start off with balanced, strategic asset allocation and then combine this with tactical asset allocation, you will also be able to benefit from short-term opportunities.

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