A common portfolio allocation mistake

Portfolio allocation means deciding how much money to invest in which asset. And most people do it wrong.

Let’s that you have 1 million francs. How much should be invested in bonds, stocks, real estate, gold, crypto, cash, etc. ? Deciding how much (in %) should go where is called portfolio allocation.

Portfolio allocation is a question all investors ask themselves because it’s at the core of the process of investing.

Dozens of books have been written and countless theories have been formulated about the best way to allocate a portfolio and it would be impossible to summarise them all here. But a common guideline is to have a high percentage of stocks when you’re young and progressively replace stocks with bonds as you age.

There are even formulas like: you should have your age in bonds. That means that, if you’re 30, 30% of your wealth should be allocated to bonds. And 70% in stocks. It’s a decent formula although it won’t be a fit for everyone.

The rational behind the formula is simple: stocks are more volatile than bonds. That means that the price of stocks changes more than the price of bonds. As you age and as your wealth grows, focus should shift from growing your wealth to protecting it from losses.

This all makes sense. But what most people tend to forget is that their wealth is not strictly restricted to their investment portfolio. It also includes their second pillar.

The second pillar is retirement money invested by a pension fund on your behalf. Each pension fund will invest the money as they please within the constraints of the law. But they are obligated to provide a net yield to the contributors. That yield is not strictly dependent on the actual performance of the fund.

For instance, if a pension fund achieves a performance of 10%, it doesn’t mean all the accounts will grow by 10%. The pension fund will provide a yield, usually between 1 and 2% and commit the rest to the reserves. And it will use those reserves to credit the accounts by the same 1-2% during the years when its performance will be -10%.

Thus, any money in a second pillar account should be treated as a bond. Aka a super safe asset. Even if the pension fund is investing in gold, real estate, bonds, and stocks. It doesn’t matter because the pension fund is required by law to provide a yield and guarantees the capital, like a bond.

But what does that mean for me?

Let’s say that you’ve decided to start your investment journey at age 30. Maybe you have 50k in the bank that you would like to invest. Should you put 15k (30%) in bonds and 45k (70%) in stocks like the formula indicates?

No, because that doesn’t consider the investment in your second pillar. Let’s say that you have 50k in your second pillar account. Your current portfolio is 50% bond (the second pillar) and 50% cash. To bring this to the desired 30% bonds and 70% stocks, you would need to devote 100% of your cash to stocks, and it wouldn’t be enough. It would only bring the stock allocation to 50%.

And it gets worse: every year, the mandatory second pillar contributions increase the bond share. So, in order to have the desired allocation, you need to keep up by investing in stocks with your discretionary savings.

Most people are shocked when I tell them that I only own shares in my investment portfolio. But that’s so risky!

Not it’s not. Because my wife and I’s second pillars are currently around 35% of our overall wealth. And every year, 20k in mandatory contributions get added to it. So everything else we invest needs to be in stocks, otherwise the bond percentage is going to grow too large for our age.

So, when you decide on your portfolio allocation (which doesn’t have to follow any rule btw), make sure that you take your second pillar into account, and count it as a bond.