Asset Allocation Basics

The three building materials

Every portfolio in this book is built from three classes of material, each doing one job:

• Equities (the growth engine). Ownership of the world's businesses. Highest long-run returns, and the full ride down in every crisis: −30% to −55% drawdowns are not tail events but recurring weather (Chapter 26 shows the record). Time is what converts equity volatility into equity returns.
• Bonds (the stabilizer). Loans to governments and companies: lower returns, far shallower drawdowns, and usually a cushion when equities fall, with 2022 as the honest asterisk this book refuses to hide (the modern-glidepath chapter takes that debate head-on).
• Cash and near-cash (the shock absorber). Money-market funds, short bills: no growth, no drama. Its portfolio role is precise and limited: the emergency buffer and near-term spending, so the invested money never has to be sold on a bad day.

Everything else you'll meet, gold, real estate, commodities, crypto, is a supporting actor auditioning for a small role (their chapters give each a fair hearing). The stock/bond/cash triangle is the frame.

Why the mix dominates everything

A landmark result (Brinson et al., properly stated): among diversified portfolios, the allocation policy explains the large majority of the variability of returns over time, roughly 90% in the classic studies. Not 90% of your return level, a common misquote, but the finding that matters is intuitive anyway: whether you held 90/10 or 30/70 through a decade will move your outcome by multiples of anything fund selection contributed. In 2008, a 100% equity portfolio fell ~50%; a 50/50 fell roughly half that. No ETF choice, no fee optimization, nothing else in this book produces differences of that size. Allocation is the steering wheel; the rest is trim.

Setting your mix: capacity, then tolerance

Capacity is arithmetic: when do you need the money? Equity drawdowns can take years to recover; money needed within ~5 years has no business riding them. A serviceable capacity ladder: money needed inside 2–3 years → cash/near-cash; 3–7 years → predominantly bonds; 7–15 years → balanced mixes; 15+ years → equity-heavy is defensible, because history's long horizons have absorbed even brutal starting points.

Tolerance is self-knowledge: what can you watch? The test that works is money-denominated, not percentage-denominated. "Down 40%" is an abstraction; "your €300,000 becomes €180,000 and stays there for three years" is the actual experience. Write down the euro loss each candidate mix implies at its historical worst, and choose the largest one that produces a shrug plus a rebalancing order, not a sleepless spiral. Everyone overestimates this in a bull market; if unsure, err one rung calmer. The expensive mistake is not holding 60/40 when 80/20 was "optimal"; it is holding 80/20 to the bottom of a crash and selling there.

The classic shortcut, stated then qualified. The old "own your age in bonds" rules (and their target-date-fund descendants) encode a true idea, de-risk as the horizon shortens, in a crude formula. Use them as orientation, not law: a 30-year-old with no buffer and shaky nerves may need more stability than the formula says; a 60-year-old with a pension covering all spending may need less. And whether de-risking should mean long bonds specifically is a live question this book treats seriously in the modern-glidepath chapter, where our house view is laid out against the classic one. Here in the foundations: the principle of matching risk to horizon is uncontested; the instrument menu for the calm side is the later debate.

Implementation: embarrassingly simple

An allocation becomes a portfolio in two or three lines: a broad all-world equity ETF (Chapter 20) for the growth slice, a broad investment-grade or government bond ETF for the stabilizer, a money-market ETF or savings account for the buffer. Two savings plans in your chosen proportions automate it (Chapter 16); one annual rebalance maintains it (Chapter 60). The one-fund alternative, multi-asset ETFs holding a fixed mix internally (an 80/20 or 60/40 in a single ISIN), trades a few basis points and some flexibility for perfect discipline, a trade many investors should happily take; Chapter 26 covers the products.

A worked example

Jonas, 35, saves €600/month, owns a €15,000 emergency fund, and needs nothing from the portfolio before ~60.

• Capacity: 25-year horizon → equity-heavy is arithmetically fine.
• Tolerance test: at 100/0, the historical-worst year turns his projected mid-career €250,000 into ~€125,000. He sits with that number and is honest: he'd hold, but grimly, and grim men fiddle. At 80/20 the worst case is ~€155,000, and his answer changes texture: annoying, survivable, rebalance and move on.
• Decision: 80/20, implemented as two savings plans (€480 world equity, €120 aggregate bonds), rebalanced each January by redirecting contributions.
• The clause that makes it durable: he writes the allocation and its worst case on one page, with the sentence "When this happens, it is the plan happening, not the plan failing." Chapter 61 is about why that page beats any forecast he could have written instead.