Most of us know why we should keep our eggs in more than one basket. But, are you aware that up to 80% of your investment returns could come from asset allocation? When trying to build a portfolio, much will depend on your stage in life. If you are newly married or starting a family, the balance of your portfolio may be quite different to that of a newly retired investor thinking of passing wealth to the next generation.
Understand your risk tolerance
One of your first considerations is to understand why you are investing in the first place. What do you want to achieve, and how many years will you wait? Patience, at this stage, will likely be well rewarded over the long term, and we recommend giving yourself enough time to set specific, meaningful investment goals. The most effective goals are genuinely aligned with our ambitions and preferences. For a retired investor, that could mean philanthropy and world travel. For someone younger, it could mean home ownership and their children’s education.
Whatever your circumstances, your ideal portfolio should meet your needs today without compromising what you wish for tomorrow.
Knowing your risk tolerance is a fundamental building block of long-term investment success. Setting personal goals will go a long way towards determining the level of risk that you are willing – and able – to take. In turn, your risk tolerance will affect the type of assets you own and, ultimately, the shape of your portfolio.
Take our retired investor, who might have spent their entire life building a business. The desire to preserve their wealth likely means they place a high value on stability. Such investors may have a lower risk appetite and be willing to accept lower investment returns. And older investors might have a shorter time horizon. For them, capital preservation could be the best strategy. Their portfolio balance is likely to be skewed towards more predictable, less volatile assets where the limited potential for income and growth is offset by the relatively high security and liquidity they provide.
In contrast, our younger investor might have a much longer-term outlook, demand higher returns and be willing to tolerate bigger swings in asset prices. Their portfolio balance will differ and likely include higher-risk assets with greater potential to build wealth. By accepting more risk, this investor is potentially willing to take more substantial short-term losses in return for higher long-term growth.
Diversify
After you gained an understanding of your risk appetite, it’s time to protect your assets for the longer term. The key word in this context is diversification. Diversification is a risk management strategy that creates a mix of various investments within a portfolio.
Systematic risks include wars, pandemics or political turbulence. These large-scale events are inevitable, and unfortunately, the only way to completely avoid them is to refrain from investing at all. In contrast, non-systematic risks only affect one particular asset, company or sector. These include poor management, financial failure and local geographic challenges. Thankfully, these concerns can be managed effectively by diversifying your assets. And perhaps that provides the most significant benefit of all: Investors with balanced portfolios sleep well at night.
But real-world investing is not always this black and white. Most portfolios are likely to contain a balance of stable, low-risk investments and a smaller proportion of higher-growth assets that carry more risk. This is something we at Julius Baer call a core-satellite strategy. In this scenario, many investors delegate the day-to-day management of the core portfolio to experienced investment professionals while retaining direct control over the remaining ‘satellite’ assets. This hybrid approach offers peace of mind about much of your portfolio yet still allows you to explore your investment ideas.
Balance your portfolio
Now that you’ve established your goals and risk appetite and recognise the benefits of diversification, it’s time to design your portfolio.
A balanced portfolio consists of different percentages of bonds, commodities, equities and other so-called asset classes. At Julius Baer, there are five strategies to consider: fixed income, income, balanced, growth and yield. Each approach is designed to offer a different profile of risk and return. If your risk tolerance is low, you might want to add more bonds to your portfolio and choose the ‘fixed income’ strategy. On the contrary, if your risk profile is very high, you might want to add a higher percentage of equities to the mix (‘growth’ or ‘yield’).
Textbooks have been written about asset allocation, which is an area where many investors seek advice from experienced professionals. In the meantime, here are three tips for budding asset allocators:
- Don’t rely on past performance as a guide to future returns. Historical correlations are often unstable and unreliable. It can be tempting to look back at how asset classes have behaved over time, but it’s like driving while staring in the rear-view mirror.
- Diversify across and within different asset types. This can help you manage risks and maximise returns. For example, if you invest in stocks, consider diversifying across different sectors and company sizes. If you invest in bonds, think about spreading your exposure across various maturities and qualities.
- Get involved! Checking stock prices too often is counterproductive, but having an emotional connection with your investments helps you to stay engaged. Once you have a better sense of your values and interests, you’ll be more likely to find assets that suit your personality and meet your financial criteria.
Rebalance regularly
Over time, the balance of your portfolio will shift. Certain assets may outperform others. When this happens, you should rebalance them so that your investments continue to support your long-term goals without running unintended risks.
For example, if your portfolio has a 60% allocation to stocks and 40% to bonds, you may become over-allocated to stocks if they outperform. Generally, stocks are considered riskier than bonds, so your portfolio may need to be rebalanced by selling stocks.
Remember, portfolios are more likely to become unbalanced when markets are unpredictable. This is when the time spent setting your investment goals will really pay: Remember your goals, stick with your strategy and invest for the long term.