Diversification is not a new topic. Jakob Fugger (1459-1525), the richest man in the world during his lifetime, used the advantages of a broad-based wealth for himself - and did so extremely successfully. He soon dominated the entire European market with fabrics, silver and copper. His wealth was well equipped to withstand crises: when fabrics suffered losses, silver was usually in high demand. Nowadays, diversification has taken on completely different dimensions and the opportunities to set up a crisis-proof portfolio are better than ever.

Strategic asset allocation (SAA) is also based on this principle. Before actually investing in the individual asset classes - i.e. buying or selling shares, bonds, etc. - a strategy should be defined. This is done as part of the upstream SAA. Long-term guidelines or investment guidelines for wealth are defined here, within which further asset management takes place.

Numerous studies have confirmed that these preliminary considerations make sense: Strategic asset allocation determines the majority of future investment success and therefore also the probability of achieving the investment objective. It is therefore an absolute must for every wealth.

What is strategic asset allocation?

The starting point for these considerations is the asset owner's investment objective: what is actually to be achieved and what role should wealth play in this? As homogeneous as the investment objectives often are (real value preservation, asset accumulation, etc.), the secondary conditions that must also be taken into account in strategic asset allocation are just as heterogeneous: What is the deposit and withdrawal strategy? Which existing assets need to be taken into account? How high is the emotional and economically acceptable risk, or in other words: How high can interim losses be? Is the investment objective actually an independent or a dependent objective because, for example, the wealth should also always serve as a source of financing for your own company? How high is the level of illiquidity that is acceptable in the asset allocation?

Obviously, when answering the questions, it is essential to look at the overall assets in order to draw up an optimal strategy. To do this, the asset owner should go through each question on wealth in detail with an advisor and the two of them then formulate the strategic asset allocation together. This results in a long-term allocation of wealth to various asset classes such as equities, bonds, real estate, private equity, etc.

The weighting of which asset classes are used is influenced on the one hand by the investment objective and on the other by the capital market environment. Asset classes have different functions and advantages in the overall assets and must therefore be included in the SAA:

• If full liquidity is essential for wealth , only liquid asset classes may be used. (see "Liquid" allocation)
• If long-term asset accumulation is the investment objective, asset classes that promise an additional return should be used. (see "Long-term asset accumulation" allocation)
• If a deflationary scenario is expected, bonds should be given very strong consideration.
• Corresponding to inflationary tendencies, asset classes that promise inflation protection.

In addition to the investment objective, the capital market situation must of course also be taken into account.

Why is strategic asset allocation so important?

There are two main reasons for this, which are rooted in the nature of the capital markets and the global economy in general: the forecasting quality of earnings expectations and the diversification effect.

As counterintuitive as it may sound, it is true that the predictability of expected returns for asset classes increases with the length of the observation period. In other words: Predicting the return of equity markets over 10 years is more likely than predicting the performance over the next 12 months. And this statement applies not only to equities, but to all asset classes.

This means that the management of wealth and therefore the achievement of targets must be strategic. This results in a further advantage: bandwidths for asset classes and loss budgets are defined based on strategic considerations. There will always be crises (coronavirus, Ukraine, etc.), which will also have an impact on wealth . However, these setbacks will not necessitate an adjustment of the investment objective, as they will hit a crisis-proof wealth and equally crisis-proof asset holders. The enemy of the private investor - high equity ratios with high equity valuations and no equity ratios with low equity valuations - can thus be systematically curbed.

The second important point in strategic asset allocation is the allocation itself. The saying "Don't put all your eggs in one basket" is very apt here. Equities, as a liquid asset class, are very susceptible to crises, as many investors sell their shares there driven by emotions, thereby triggering a snowball effect. This risk should be offset by other asset classes (illiquid) that are more crisis-resistant. Examples include private equity or real estate, but also gold and liquidity. With an optimal allocation, investors receive a portfolio that stands on several secure pillars and a large or even complete loss of assets seems almost impossible. The basis for this is created in strategic asset allocation.

‍

Rebalancing and recalculation in strategic asset allocation

Neither the wealth nor the strategic asset allocation should be set in stone, but should constantly adapt to market conditions. In technical terms, this is done through rebalancing and recalculation.

If market developments cause the actual weightings of the asset classes in wealth to move away from the target weightings of the strategic asset allocation, countercyclical action must be taken and the wealth adjusted to the SAA. This can be explained using the asset class equities as an example:

• If equity markets are bullish and the weighting of shares in wealth rises above the strategic target weighting, shares must be sold and profits taken in order to correct the imbalance.
• The situation is mirrored when stock markets fall: The weighting of shares in wealth falls below the strategic target, in which case shares must be acquired counter-cyclically.

In the context of recalculation, the adjustment is different: here, the strategic asset allocation itself changes because the input parameters for the SAA itself have changed due to changes in the framework conditions on the capital markets. The key factor here is the return expectations for the asset classes. The diagram below shows how changed earnings expectations have a countercyclical effect on wealth .

‍

• The starting point is a neutral return expectation for equities of 5% p.a. over the next 10 years. The strategic equity weighting in the example case would then be 47.3%.
• If the expected return on equities falls below 3% p.a., e.g. due to very strong stock market rises ahead of economic reality, the strategic equity weighting must be adjusted downwards to 32.9% as an example. Holding on to or holding more equities would not increase the probability of achieving the target, but would merely increase the risk at wealth .
• If, on the other hand, the expected return on equities rises to over 7% p.a., e.g. because the stock markets have fallen sharply but the economic outlook is positive, the strategic equity weighting should be increased. An increase in equities in wealth increases the probability of achieving the target and the inherent risk is justified.

The above combination of rebalancing and recalculation for equities must be carried out continuously for all asset classes so that the wealth is optimally adapted to each situation. A rebalancing in wealth takes place precisely when the adjusted SAA results in a significant increase in the probability of target achievement.

Why is strategic asset allocation underutilized?

Many investors are not aware of the impact of strategic asset allocation on their investment objective. The SAA should be at the beginning of every investment consultation. This is where the foundation is laid for the success of the portfolio and the achievement of the desired goals. Especially when it comes to wealth planning over a longer period of time, strategic asset allocation is indispensable.

Strategic Asset Allocation is a process in which each client and their total assets are first considered individually. The SAA is based entirely on the client's preferences, circumstances and requirements. As a result, a detailed SAA is usually only offered in a family office, as the focus there is on the holistic wealth and not on individual asset classes or investment solutions as is the case with banks and asset managers. And if this is the case, clients are often assigned to a corresponding standard SAA or a model portfolio depending on their risk profile, which is identical for all clients with the same risk profile.

At FINVIA, we go one step further. We create an individual strategic asset allocation for each of our clients that is perfectly tailored to their needs. Why can we offer this? Because we advise our clients holistically across all asset classes, free from conflicts of interest and independent of any specific product. In addition, FINVIA has developed an efficient process using state-of-the-art technology to offer each client an individual SAA that meets their personal return target and risk tolerance, across liquid and illiquid asset classes, continuously monitored and dynamically managed.