What is asset allocation?
Asset allocation is basically nothing more than the distribution of your money among different asset classes. That is why it is often referred to as asset allocation. The selection and weighting of the different assets is crucial for wealth accumulation. Before we go any further, let's briefly clarify what an asset and an asset class are.
An asset is an asset such as a company shareholding, a property or even an NFT. An asset class (also called an asset class) groups together assets that are similar in terms of risk and return profile. The best-known asset classes include:
- Shares
- Bonds
- Real estate
- Crypto stocks
- Art
- Cash reserves (cash assets)
Asset classes can also be divided into subcategories. Shares, for example, can be divided into small, mid and large caps depending on the size of the company. Not only the size, but also the industry or geographical characteristics can define an asset class. Crypto assets are also not all the same and can be divided into utility tokens, security tokens or NFTs, among others.
Now you know what assets and asset classes are - let's take a look at asset allocation in wealth accumulation.
The role of asset allocation in wealth accumulation
In principle, anyone who builds up assets distributes their money among various asset classes. Depending on the percentage weighting of the respective asset class, the risk-return ratio of the overall portfolio changes.
An example: Let's say we have €10,000 to invest - how do we invest the money? That depends on our risk profile. We distinguish between high-risk asset classes (with high return prospects) and low-risk asset classes (with little to no return). High-risk asset classes include:
- Shares
- Private equity
- Bonds (low credit rating)
- Real estate
- Crypto stocks
- Art
- Tangible assets
- Raw materials
Low-risk asset classes, on the other hand, include:
- Savings deposits (time deposit, call money and savings book)
- Current accounts
- Government bonds (high credit rating)
The higher the potential returns, the higher the underlying risk of an asset class.
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If you tie up large parts of your capital in just one asset class, you run a so-called cluster risk. In this case, the development of assets is dependent on only one asset class. Those who want to reduce their portfolio risk should therefore rely on different pillars.
What exactly we mean by this, you will learn in the next section.
Diversification as the key to a better risk-return ratio?
Does it make sense to concentrate all your assets in one asset class? If you want to minimise your risk, then probably not. In this case, a broad diversification of investments may be the more sensible way. The idea behind this is based on portfolio theory, for which Harry Markowitz received the Nobel Prize in Economics in 1990.
The idea behind the theory is quickly explained: different asset classes are subject to different risks. A broad distribution of your capital can balance out the risks. To achieve this, it is important that there is as little correlation as possible between the asset classes. In the past decades, this was the case, for example, between shares and gold. If shares lost value after the global banking crisis (2007/08), the gold price reached new highs, as the precious metal is still seen by many as a crisis currency and benefited from the demand. This opposite development is also referred to as negative correlation and is a good prerequisite for minimising risk.
In recent years, many alternative asset classes have also become investable for small investors. In addition to real estate, art and other tangible assets, we at Tokenstreet are currently working on a digital investment app that allows small investors to invest indirectly in private equity (PE) from €100.
As an investment, PE has proven to be crisis-resistant, especially in turbulent stock market phases . Many institutional investors (banks, insurance companies, family offices) allocate large portions of their client assets to this asset class and achieve above-average returns.
Important note: Despite the advantages, private investors should not lose sight of the high default risks of private equity. A large proportion of investment companies fail. If these losses are not compensated, investors can lose large parts of their invested money. Since the capital commitment period is relatively long (>9 years), investors normally only have access to their capital prematurely at a high discount. Total losses cannot be ruled out due to the uncertainties associated with this asset class.
Before asset allocation: Define and review investment objectives
Before investing money, concrete investment goals should be defined. With our example we could show how private investors could weight the different asset classes in their portfolio. However, investment objectives can be subdivided as follows:
- Short-term goals (0-3 years): Travel, new laptop, kitchen
- Medium-term goals (4-9 years): World trip, sabbatical, new car, real estate
- Long-term goals (>10 years): Retirement provision, children
Financial experts generally advise against investing short- and medium-term goals on the capital market. If there are strong price fluctuations, it can happen that the money for certain goals is no longer available and has to be financed in the short term by loans.
Imagine you invest €3,000 in NFTs that you want to sell again next year to finance a trip to Iceland. If the market falls by 40% shortly before the booking, you lose €1,200 in capital. The risk of loss would have been much lower in a low-risk asset class.
For this reason, define your goals before asset allocation and adjust the weighting of your investments accordingly. The longer the investment horizon, the easier it is to compensate for short-term fluctuations. The weighting also depends on your risk profile. Ask yourself how well you can handle price fluctuations. If you panic even at marginal movements, the same applies here: only add risky asset classes to the portfolio in small portions.
This is what we can learn from institutional investors
Institutional investors or high-net-worth investors (HNWIs) are fundamentally more experienced and strategic in their asset accumulation than retail investors. This is often because they have experienced advisors who manage their asset allocation.
However, there are many lessons to be learned from their investment style, which we will briefly summarise for you below.
- Institutional investors define their investment strategy and stick to it in the long term
- They are aware of their risk profile and avoid speculative transactions outside their tolerance limit
- In some cases, they hold high cash holdings in order to profit from low prices in the event of a market correction
- They have access to alternative asset classes such as private equity, art or classic cars due to their network and classification as a professional investor (250,000 euros) and can thus diversify their portfolios
- You have a long-term investment horizon
