Asset allocation: the 6 key points for an investment portfolio that works

To build a strategic asset allocation and therefore a good investment portfolio, one must pay attention to the expected returns, risk, volatility and liquidity of the investments, historical moment, and it takes competence.

how to build an asset allocation

I often talk about ETFs and how to use them, about automated investment systems such as Capital Accumulation Plan, I try to explain how to invest in bonds or stocks and the different investment approaches… But at a certain point we ask ourselves a legitimate question: “In short, but of all these tools and strategies which should I use and why can’t I invest directly on what makes the most?”.

The answer is asset allocation which, to put it in a non-technical language, is nothing more than the way you decide to organize your asset availability in different sectors, possibly using different strategies, attributing to each sector or strategy a certain percentage of your resources.

Without pretending to exhaust such an important and complex topic in an article on the blog, I start by saying that to build an effective asset allocation that meets our specific needs it is necessary to consider and balance the following 6 factors.

Understanding and balancing these 6 key factors within one’s investment asset allocation is essential: there is no universally valid magic recipe because between one person and another important elements such as age, family and property situation, present work situation and future, emotional tolerability of risk and volatility, haste to reach certain financial targets etc.

Diversifying investments with little discernment is a senseless activity, instead building an asset allocation that takes into account all these elements is fundamental for one’s financial future.

1 – How to build an asset allocation: expected return

Each asset class (shares, bonds, forex, real estate, commodities, etc.), but above all each operational strategy, has its own reference yield which, on average, is obtained with a certain constancy within a given historical period.

It being understood that the minimum objective is the cancellation of inflation, from then on obviously the more our savings make, the happier we are. Speaking of annual yield, we can thus start from 3-4% typical of the current bond market, to 8% of the automated PAC without large external interventions, to 10-30% of active trading strategies.

The return is certainly a key element but it is not all, in fact it must be balanced with the risk and volatility.

2 – How to build an asset allocation: risk and volatility

The typical equation high yield = high risk is not always true, in fact, we should rather speak of high volatility instruments, because volatility is the characteristic that can give rise to important returns on the one hand but also to large losses on the other.

Volatility and risk are not the same, because the risk depends a lot on the strategy and the competence with which you operate and on the attention you decide to devote to your investments.

To understand: if I buy stocks, funds or equity ETFs without paying particular attention to the timing of the purchase and then left them there with a hold approach, when I go to look at them later I could be in big gain as in big loss precisely because they are very volatile instruments.

Volatile investments are also called risky because many investors do not know what they are doing and with which technical criteria to operate (which is obviously always a wrong thing to do). This then leads us to the next key element.

3 – How to build an asset allocation: competence

Different tools and strategies require different skills, more or less complicated or long to acquire in order to be used successfully.

Among the skills needed to invest, one should never underestimate the importance of experience which is what provides you with the indispensable transition from “knowing” to “knowing how to do”: in every job or discipline they are two different things and with different times of acquisition.

Last but not least, you need a certain emotional competence and mastery of your emotions, the latter factor typically underestimated but extremely important when operating with volatile instruments such as actions or even leveraged.

One way to get around the obstacle of emotion can certainly be to operate through automatic systems or strategies which, once set, never or almost never require human intervention. In this way, not only is the need for a strong emotional competence reduced, but it also acts positively on the next element.

4 – How to build an asset allocation: commitment and time

The more time and attention you devote to your investments, the more you are in control of what is going on. If you also have the competence to know what to do, this is certainly an element that benefits the maximization of profits and at the same time the minimization of investment risk.

The problem is that time and desire are resources that we typically lack, especially if our main professional activity is another. This is why it is necessary to balance the various strategies and asset classes of investment between fully automatic systems (income or passive yield) to those that require a more or less important amount of daily or weekly attention.

Informatic technology and specific expertise in this area are important: for example, knowing how to use the various software available for trading and how to use automatic orders (entry orders, stop loss and take profit) can certainly save significant amounts of time (if we talk about active trading, a little commitment must always be considered).

5 – How to build an asset allocation: liquidity and time axis

Some investments place limits on the liquidity of their assets, for example by entering penalties or contractual obligations in the event of early divestment. In other cases, investment liquidity is immediate from a technical point of view but slow or complicated in practice (think of the sale of a property or a work of art).

Then there are assets and strategies that have an excellent relationship between the expected return and the related risks, but that make sense only in the medium-long term perspective while they lose their sense or functionality in case you want to use them to produce cash flow on a constant basis, to increase or replace one’s main income.

6 – How to build an asset allocation: understand the historical moment

Finally, it is necessary to consider the historical moment we are going through. At a given market moment one financial instrument tends to be favored rather than another: this must be taken into account, varying the percentages of attribution of the portfolio to individual assets or individual investment strategies.

Other elements can also be taken into consideration, such as the correlation between bonds and stocks, the risks and difficulties (external or system) to be prevented or countered in some way, the amount and the form of taxation that weighs on the various instruments.

Waiting for your comment or your question, I would like to reassure you that if everything seems complicated or difficult to learn, well, it is not. Of course, you cannot learn everything in one day, you need some time and above all practice and experience to refine your investment strategy and make the contents learned from courses and books concrete. But we are not talking about cardiac surgery or missile science for which mastery takes 5 years of university.

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