Asset allocation as the main decision
Asset allocation means dividing capital among asset classes with different return and risk characteristics. For a diversified portfolio, this strategic decision usually has a greater influence on the variability of long-term results than the choice of individual securities.
| Asset class | Role in the portfolio | Main risks |
|---|---|---|
| Equities | Long-term capital growth, dividends | High volatility, issuer-specific risk |
| Bonds | Relatively predictable income, stabilization | Interest rate risk, credit risk, inflation |
| Cash and deposits | Liquidity, a reserve for opportunities and emergencies | Low or negative real return in inflationary periods |
| Alternative assets | Additional diversification | Low liquidity, difficult valuation, costs |
Strategic allocation sets the long-term target weights, while any temporary deviations from those weights based on market views fall under tactical allocation. For most individual investors, a clear strategic allocation that is followed consistently matters more than attempts to predict short-term market movements.
Correlation and the diversification effect
Correlation (ρ) measures how closely the returns of two assets move together and ranges from −1 to +1. The lower the correlation, the more often declines in one asset tend to be offset by the other, and the portfolio's risk falls below the weighted average of the individual risks.
| Correlation ρ | Variance (%²) | Portfolio σp |
|---|---|---|
| +1.0 | 207.36 | 14.40% |
| +0.2 | 161.28 | 12.70% |
| 0.0 | 149.76 | 12.24% |
| −0.2 | 138.24 | 11.76% |
Specific risk and systematic risk
Diversification reduces specific risk (tied to an issuer or a sector), but it cannot eliminate systematic risk (market risk), which affects most assets at the same time: recessions, interest rate shocks, liquidity crises.
- Diversify across asset classes, not just across securities within the same class.
- Avoid excessive concentration in a single issuer, sector or currency.
- Take the liquidity of instruments into account: in thinly traded markets, exiting a position can take time.
The investor's risk profile
The right allocation depends on your capacity to bear losses (time horizon, income, obligations) and on your psychological tolerance for volatility. An investor with a long horizon and stable income generally has a greater capacity to absorb fluctuations than one who will need the money in two years.
| Illustrative profile | Typical horizon | Allocation characteristics |
|---|---|---|
| Conservative | Short | Predominantly fixed-income instruments and cash |
| Balanced | Medium | A relatively even mix of equities and fixed-income instruments |
| Dynamic | Long | Predominantly equities, accepting high volatility |
Key takeaways
- Allocation across asset classes is the main strategic decision for a diversified portfolio.
- The lower the correlation between assets, the further portfolio risk falls below the weighted average of individual risks.
- Diversification reduces specific risk, but not systematic risk.
- Allocation should reflect the investor's horizon, risk capacity and risk tolerance.
Check your knowledge
Answer all the questions. If you answer all of them correctly, the lesson is marked as completed automatically.
Explanation: E(Rp) = 0.6 × 12% + 0.4 × 7% = 7.2% + 2.8% = 10.0%.
Explanation: At ρ = +1 there is no diversification benefit, and σp = w1σ1 + w2σ2.
Explanation: Systematic risk affects most assets at the same time and remains present even in a well-diversified portfolio.
Educational material only. It does not constitute investment, legal or tax advice. Numerical examples are hypothetical.