Investing Course – Chapter 2 – Level 1 Asset Allocation

Welcome to the second chapter of our investing guide, where we’ll dive into the essentials of Asset Allocation Level 1 (L1AA). If you missed the first chapter, we concluded that most people should primarily focus on low-cost, globally diversified ETFs to build long-term returns. If you haven’t watched it yet, feel free to check it out.

For this guide, we’ll be using insights from the book Souverän Investieren—currently one of the most authoritative resources for passive investing in Germany from Gerd Kommer. Specifically, we’ll focus on Chapter 10.2, which is all about determining your Level 1 Asset Allocation. This second chapter was initially recorded as a Power Point presentation. You can find the video with quotations on my YouTube Channel.

But before we dive in, here are a few important notes:

Disclaimer: This is not professional financial advice. The information shared here is based on my own research and understanding, but things change over time. Always do your own research, especially before making major financial decisions.
Questions: This is a small channel with a tight-knit community. If you have any questions—even long ones—feel free to drop them in the comments. Chances are, I’ll have time to respond!

The Basics: Building Your Liquidity Reserve

Before you jump into investing, one of the first steps is building a liquidity reserve. Simply put, this is a cash buffer to protect you from unexpected expenses that might pop up. Think of it as your financial safety net.

What kind of unexpected expenses are we talking about? That could be:

Your phone breaks or gets lost
Your washing machine dies unexpectedly.
You lose your job (especially if you don’t have a strong social safety net).

The key point here is that unexpected costs happen to everyone, even if we try to plan for them. And without a liquidity reserve, you may have to borrow money, potentially using an overdraft account or selling off your investments to cover the cost. This leads to two key problems:

Overdrafts: Many banks have high overdraft fees. If you don’t have enough funds in your account, you may face these expensive penalties. It’s better to avoid them entirely.
Selling Investments: If you have to sell parts of your ETF portfolio to cover an emergency, you might be selling at a loss—especially if the market is down at the time. This reduces your potential long-term returns, and it could lead to tax inefficiencies depending on your situation.

But beyond the financial implications, having a liquidity reserve also provides something invaluable: mental stability. Knowing that you have the cash available to replace your phone or pay for emergency repairs means you won’t have to stress about where the money will come from.

Now, how much should your liquidity reserve be? According to the book, the general recommendation is to have enough to cover four to ten months of your living expenses. The amount really depends on your situation:

If you live in a country with a strong social safety net, like Germany, and have family or friends you can rely on, you might lean toward the lower end of that spectrum.
If you live in a place like the U.S., where social welfare is less comprehensive, and you don’t have family support, you might want to have a higher reserve.

Ultimately, the goal is to have enough liquidity to handle emergencies without disrupting your investment strategy. But also, don’t overdo it. Keeping too much money in a liquid reserve means you miss out on long-term investment returns. The idea is to find the right balance—enough liquidity for peace of mind, but not so much that you’re sacrificing future returns for security.

When to Adjust Your Liquidity Reserve

Your liquidity reserve isn’t something set in stone. It can and should be adjusted based on your needs and life changes. If you find yourself dipping into it more often than expected, it may be time to increase the amount. Alternatively, if you’ve built up a strong financial cushion and find you’re not tapping into it, you may choose to reduce the reserve and invest the difference.

Remember, the liquidity reserve is meant to cover emergencies only. You don’t want to use it for normal expenses or lifestyle choices. For example, if you buy an expensive item or make an impulse purchase, it’s better to pay for it from your regular income rather than touching your emergency fund.

Level 1 Asset Allocation: The Key Decision

Once you’ve built up your liquidity reserve, the next step is deciding how to allocate the rest of your money. This brings us to Level 1 Asset Allocation (L1AA).

At this stage, you need to decide how much of your portfolio will go into low-risk assets (like bonds or cash) versus higher-risk assets (like stocks or ETFs). Here’s the reasoning:

Risk and Return: The more risk you take on (by investing in stocks), the higher your potential return. But risk comes with volatility. Stocks, for example, can have high short-term fluctuations, but they generally outperform bonds over the long term.
The Balance: The trick is finding the balance between risk and return that suits your personal financial situation and psychological comfort. The more risk you’re willing to take, the more potential long-term gains you’ll see—but it’s important to be prepared for periods of volatility.

Why Not Go All-In?

You might be tempted to put everything into high-risk investments like stocks or ETFs because of the higher returns they promise. However, there’s a caveat. For example, U.S. stocks had a period between 1968 and 1983 where they had no real (inflation-adjusted) growth for over 14 years.

But this doesn’t mean that if you invest in stocks today, you’ll have to wait 14 years for returns to kick in. In real life, most investors don’t put all their money into stocks at once and then sell everything at the same time again. They invest and divest gradually. This reduces the likelihood of experiencing such long stretches without returns.

Historically, a 100% stock portfolio with zero returns for up to 12 years was not that uncommon. Therefore, the key takeaway is that you need to be mentally prepared for the possibility of low or zero returns over a decade.

Deciding Level 1 Asset Allocation

When deciding on your Level 1 Asset Allocation, consider how much volatility you’re willing to tolerate and how much risk is appropriate for your financial goals. The more risk you take on, the higher the potential long-term returns, but the journey might include significant bumps along the way.

So, before making decisions about how to allocate your investments, remember:

Start by building your liquidity reserve to cover unexpected expenses.
Once your emergency fund is in place, focus on allocating the rest of your funds between low-risk and high-risk assets according to your risk tolerance and financial goals.
Don’t invest money you might need in the short term, and be prepared for ups and downs in the market.

The Benefits of a Lower-Risk Portfolio

Not everyone is equipped to withstand the stress of severe market drops. For some, the psychological impact of a 50% or 60% decline in the value of their portfolio could be detrimental to their mental health and overall well-being. This is where adding a low-risk portion to the portfolio becomes beneficial.

Including safer assets—such as government bonds, money market instruments, or other low-volatility investments—can help lower the overall risk of your portfolio. It’s similar to choosing the alcohol percentage in a cocktail. While a 100% alcoholic drink might make for an exciting night, it also increases the chances of negative outcomes. Similarly, a portfolio composed entirely of high-risk assets may offer great returns, but it also brings a greater risk of loss that might cause undue stress.

This concept is particularly important in today’s world of instant portfolio tracking. With the proliferation of mobile apps, investors now have immediate access to their portfolio’s performance. If your portfolio takes a steep dive, seeing those negative numbers can trigger feelings of anxiety and panic, making it harder to stay the course. Therefore, adding a buffer of low-risk investments can mitigate the emotional toll.

Psychological Stress and Portfolio Performance

An essential consideration when deciding on your portfolio composition is how you react to financial stress. The risk of market crashes or substantial losses is inherent in any investment strategy, but how you handle these situations is equally important. Many seasoned investors can endure downturns without much concern because they trust the long-term growth potential of their investments. But for others, the experience of seeing red numbers in their portfolio can be overwhelming.

If the thought of a market correction—where your portfolio might lose 50% or more of its value—keeps you up at night, it’s a sign that your risk tolerance may not align with an aggressive, 100% risky portfolio. In such cases, it’s wiser to include more conservative investments in your portfolio to maintain a balance that feels comfortable for you psychologically. After all, the ultimate goal of investing is not just optimizing returns, but also preserving your peace of mind.

Adapting Your Portfolio as You Learn

If you’re just beginning your investing journey, it’s natural to feel apprehensive about large market fluctuations. If you’re unsure about your ability to handle volatility, start by allocating a higher percentage of your portfolio to safer assets. Over time, as you gain more experience and confidence in your strategy, you can adjust your portfolio to include a larger share of risky assets. The flexibility to adapt as you learn more about yourself as an investor is key to achieving long-term success.

On the other hand, if you start out with a more aggressive portfolio—say 100% invested in risky assets—and find that you struggle to deal with the emotional stress during downturns, you can always reallocate. It’s perfectly fine to reassess and adjust your approach to ensure it aligns with both your financial goals and your mental well-being.

Managing Risk and Understanding Portfolio Composition

In building a diversified investment portfolio, the mix of risky and safe assets plays a crucial role in determining the portfolio’s long-term success. While the theoretical framework around risk and return is well established, actual market conditions can shift over time, making it important for investors to adjust their approach based on up-to-date information. This section discusses the importance of adapting to changing market conditions, the potential for factor investing, and the necessary considerations when creating a balanced portfolio.

Factor Investing: A Potential Strategy with Higher Risk and Return

One investment approach discussed by Kommer is factor investing—an investment strategy that targets stocks based on factors like value, momentum, quality, size, and low volatility. Factor investing can offer higher long-term returns but typically comes with higher volatility and lower diversification compared to more traditional, market-neutral investing strategies.

While Kommer advocates for factor investing, it’s not without its drawbacks. The added complexity and volatility may not suit every investor’s risk tolerance, especially those looking for a more stable, diversified portfolio. For this reason, it’s important to understand the implications of factor investing, which will be explored further in Chapter 3. I personally are not that convinced right now of the usefulness of Factor Investing.

ESG Investing: Trade offs?

Another consideration for modern portfolios is Environmental, Social, and Governance (ESG) investing. It is likely that ESG-focused ETFs would yield returns similar to those of traditional stock market investments—albeit potentially with slightly lower returns due to the added screening criteria for ESG factors. If you are considering adding ESG elements to your portfolio, be mindful of the possible trade-off between ethical investing and the risk/return profile that suits your overall financial goals.

Understanding Maximum Drawdown and Risk Tolerance

To help visualize different portfolio allocations, Kommer presents a table of maximum draw downs for various levels of risky and safe asset allocations. The draw down represents the peak in portfolio value, which is particularly important for those who are risk-averse. It’s essential to choose an asset allocation that aligns with your personal risk tolerance. If you feel uncomfortable with the idea of losing more than 30% or 40% of your portfolio’s value during a downturn, you might want to reduce your exposure to risky assets. Conversely, if you have a longer investment horizon and a higher tolerance for risk, you may opt for a more aggressive, higher-risk portfolio. If you are going for a safer portfolio composition, you could use this table from Komemr as guidance. But keep in mind, the calculations are from August 2024 and might not be that accurate anymore if the interest level changed a lot in the meantime.

For 100% equities portfolio, Kommer states a maximum nominal draw down of -53%, expected real return before costs and taxes 5,5% p.a. for market neutral portfolio and 7% p.a. for a factor investing portfolio. For a portfolio consisting 50/50 of risky and safe investment, these numbers change to -26% for the draw down, 3,5% p.a. for the market neutral portfolio and 4,25% for the factor investing portfolio. For a portfolio consisting 100% of safe assets, the maximum draw down would go down to a mere 2%, 1.5% return for the market neutral portfolio and factor investing portfolio this time. I would like to share the entire table with you, but it is not my own intellectual property and calculation, that is why I can only share this extract with you.

Outlook

Thank you for reading this chapter. In the next chapter, we are going to look at other assets classes besides stocks we might want to put into our risky part of our portfolio.