What is asset allocation?
If you want to take control of your finances, defining a strategic asset allocation will be your starting point before venturing into the stock market. Then, you can select the indices you want an exposure to and invest in the corresponding exchange-traded funds (ETFs) – or in mutual funds if appropriate in your jurisdiction. You can then decide to invest based on the currency and relative price of the markets.
In summary, you should follow these three steps before investing:
- Define your strategic asset allocation for your situation (currency and international market exposure).
- Select an index covering each component
- Select the ETF for each index
So many things can go wrong that you should only apply a personal approach to managing currencies and different markets if you have educated yourself sufficiently, otherwise you risk making major mistakes.
That is why in most cases (and sorry for the repeated mantra), you should invest a simple, broad portfolio. You can consider three equity sub-portfolios with for example your home country, developed markets and emerging stocks. Taking too many individual positions in your portfolio and going back and forth is unlikely to be profitable in the end, although you can sometimes improve your results by trading and buying stocks when they are more attractive. The key principle of diversification applies here because it prevents a total loss of your assets.
The one thing you have to avoid is the risk of ruin. (…). Stay out of things that could cause you to lose all of your capital, all of your savings. Don’t gamble everything on one go.
Naval Ravikant’s Almanac by Eric-Jorgenson
So you should avoid concentrating your assets in one company or even one country (like your home country). Instead, look for international diversification.
International Equity Asset Allocation
Your international allocation will depend on your need for diversification and your desired currency exposure. If you live in the U.S., you may have less need for international diversification or foreign currency exposure compared to a citizen of a smaller country like Switzerland (where your domestic stock market exposure will be concentrated in a few stocks).
Over the past 10 years, the best and simplest investment strategy would have been to invest exclusively in a global portfolio (e.g. with a single ETF). The near end of expansive fiscal and monetary policy and the high valuation of U.S. growth stocks may require a different decision about your future asset allocation. As with most good strategies, a strong trend does not last forever (or in simplistic terms, it works until it doesn’t!). Currently (end of 2021), the overvalued ETFs are US Growth stocks and there is a higher risk of correction compared to less valued investments. Retail investors have most likely to gained exposure to those currently very expensive stocks by investing in the MSCI and FTSE developed market indices (through the corresponding ETFs).
Your equity asset allocation and your international allocation will determine the main components of your portfolio. For example, if your European allocation is 50%, your portfolio could consist of one ETF covering this market or several ETFs totaling its share of your portfolio (i.e. half in this illustrative case). If you are looking for a low cost ETF, the Eurostoxx 50 covers the 50 largest European stocks. The problem is that it had an attractive P/E in the first part of 2020 and quickly became more expensive because of the flood of central bank liquidity.
Managing the complexity of your asset allocation
If you can manage a more complicated portfolio, you could have a core ETF and other low-cost country-specific ETFs with lower P/Es (and sometimes lower fees as well). For simplicity, start with an ETF with low fees and a reasonable P/E. Otherwise, this would already be a type of market timing that goes further than pure passive investing leading to a higher risk of error (even if it is not yet stock picking). If you follow this more detailed approach to index and ETF selection, pay attention to the following tips:
- Look specifically for constituents (European ETFs may include U.K. companies with exposure to the British pound or large Swiss stocks) ;
- A high number of constituents (i.e., as many different stocks as possible for a given market) is generally preferable, but this should not come at the expense of low fees;
- You should avoid style (growth and value), active or factorial (small or large cap) indices, as they distort your view of the market and cost more.
- Try to keep your allocation target long-term. If some components are currently overvalued, focus on better deals while you build your ETF portfolio, but keep your final destination (a well-balanced equity portfolio) in mind.
What to do with your asset allocation plan
If you are not interested in the markets but want to control your costs, it is always better to invest in ETFs based on your asset allocation rather than in your traditional bank that charges stratospheric fees that are not always transparent. For this, you can consult the resources on this site.
Another option would be a properly priced robo-advisor, if available at an acceptable price in your jurisdiction, or a competent advisor with an affordable fee (which is very rare).
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