Asset Allocation: Mixing Equities, Bonds and Cash for Your Risk Level

What you will learn

• What strategic asset allocation is and why it drives most of a portfolio's risk.
• The roles of equities, bonds and cash in a long-term portfolio.
• How to calculate a maximum equity share from your acceptable loss with a stress test.
• How the allocation can change as a goal date approaches.

Explanation

Asset allocation is the split of your investments between asset classes. Strategic asset allocation is the long-term target split you write down and keep, for example "60% equities, 40% defensive". For a portfolio of broad index funds, this split determines most of how much the portfolio can fall; the choice between two similar world ETFs matters far less.

The building blocks:

• Equities (shares, usually via a broad global ETF): the growth engine, with the highest expected long-term return and the deepest possible falls.
• Bonds (loans to governments or companies): interest income and usually smaller price swings; high-quality short-term bonds fluctuate least. Interest-rate and credit risk of bond ETFs follow in lesson 8.
• Cash (Tagesgeld, Festgeld, money-market funds): stability and liquidity. Your emergency fund is separate from the investment portfolio (see "Personal Finance & Money Management").

We call the combined bonds and cash part the defensive part. The equity share is the main "risk dial".

Simple age rules such as "100 minus your age in equities" ignore your actual finances. A more personal method is a stress test: decide the maximum temporary loss you accept (from lesson 1), assume a severe fall for each part, and solve for the equity share e:

accepted loss % = e × equity fall % + (1 − e) × defensive fall %

e = (accepted loss % − defensive fall %) ÷ (equity fall % − defensive fall %)

For the equity fall, 50% is a sensible stress value: in the 2007–2009 financial crisis, the MSCI World fell by roughly half (figures differ by currency and source). Future falls can be larger. For a high-quality defensive part, a stress loss of around 5% is a cautious hypothetical assumption; longer-dated bonds can lose more when interest rates rise.

A goal with a fixed date needs a glide path: the equity share is reduced step by step as the date approaches, so a late crash cannot destroy the goal. For an open-ended goal such as long-term wealth, the allocation can remain stable and is reviewed when your life situation changes.

Worked example

Hypothetical example: Carla invests €50,000 for the long term. After her emergency fund, she decides she can accept a temporary loss of €10,000. Assumptions: equity stress fall 50%, defensive stress fall 5%. Costs, taxes and currency effects are excluded.

1. Accepted loss in percent: €10,000 ÷ €50,000 = 20%.
2. Equity share: e = (20% − 5%) ÷ (50% − 5%) = 15 ÷ 45 ≈ 33.3%.
3. In euros: equities ≈ €50,000 × 33.3% ≈ €16,667; defensive part ≈ €33,333.
4. Check: €16,667 × 50% + €33,333 × 5% ≈ €8,333 + €1,667 = €10,000. The stress loss equals her limit.
5. If Carla had chosen 60% equities: €30,000 × 50% + €20,000 × 5% = €15,000 + €1,000 = €16,000, far above her limit.

Carla now has a written, testable allocation instead of a feeling.

Common mistake

Practice activity

On paper: you have €80,000 to invest and accept a temporary loss of €12,000. Assume an equity stress fall of 40% and a defensive stress fall of 5%.

1. Calculate the accepted loss in percent and the maximum equity share.
2. Convert it into euros and check the stress loss.

Key takeaways

• Strategic asset allocation, mainly the equity share, sets most of a portfolio's risk.
• Use a stress test: e = (accepted loss − defensive fall) ÷ (equity fall − defensive fall).
• Keep the emergency fund outside the portfolio and reduce equities step by step before fixed goal dates.
• Write the allocation down and do not raise it just because markets have done well.

Next step

In the next lesson you will look inside the defensive part: bond ETFs and money-market funds, and their interest-rate and credit risk.