Asset Classes Defined
It is generally accepted that a key decision for investors is how to divide their investments between different asset classes. This is known as asset allocation.
In order to decide how to divide or allocate your investments (your financial assets) between the different asset classes, it is useful to understand what we mean by asset classes and what the different classes are.
The three main asset classes are Stocks (equities), Bonds (fixed income) and Cash.
According to Investopedia.com an asset class is: “A group of securities that exhibit similar characteristics, behave similarly in the marketplace, and are subject to the same laws and regulations.”
Investopedia notes that “in addition to the three main asset classes, some investment professionals would add real estate and commodities, and possibly other types of investments, to the asset class mix.”
Investopedia argues that asset classes can be divided into sub-categories such as longer term bonds and short-term bonds within the larger Bond (Fixed Income) asset class.
There are some major problems with the notion that there are three broad and distinct asset classes.
Cash, which includes bank deposits and short-term money market deposits which tend to pay little or no interest (especially after inflation) is a distinct asset class.
Equities or Stocks however is an extremely broad category and really fails to meet the requirement that an asset class consist of similar assets with similar risk characteristics. Common equity shares are vastly different than preferred share equities. Common shares represent a claim on the residual cash flows or profits after all expenses are paid including interest on bonds and including preferred share dividends. Common shares also represent the ability to appoint directors to manage the company. Preferred shares are vastly different in that they usually represent a claim on a fixed dividend payment per year. They are not entitled to any residual income and the dividend is not increased if the company becomes more profitable. Perpetual preferred shares arguably have more in common with extremely long-term bonds. Many analysts would classify preferred shares in the fixed income rather than the equity category.
Common shares of a long-established profitable company that pays a substantial dividend are also quite different and vastly less risky than the common shares on an early-stage company that is not yet even profitable.
Bonds are also a broad category. A 50-year bond will change value dramatically if interest rates double whereas a one-year bond is affected very little by a doubling in interest rates. The bonds of some companies are highly risky and the interest will only be paid if the company is sufficiently profitable and in some cases this is much in doubt. These high yield bonds may behave more like common equity shares than investment grade bonds. High yield bonds can increase dramatically in price as the profitability of a corporation improves.
For Retail Investors Securities Chosen ultimately determine Returns, not asset classes
There is a lot of mis-information when it comes to the extent to which asset classes as opposed to individual securities determine portfolio returns.
It has often been reported that 90% of returns are driven by asset allocation as opposed to the individual securities selected. This is true only if one is extremely well diversified within each asset class. This “rule” may therefore apply to institutional investors like pension funds which are very well diversified within each asset class. For the most part, various pension funds will have similar exposures to short-term versus long term bonds, to government versus corporate bonds, to bonds with high credit ratings versus high yield junk bonds, to U.S. bonds versus global bonds etc. If various pension funds are holding various percentages of asset classes and if within each asset class the average characteristics of the securities are similar (and the average characteristics of the securities in their asset classes must be similar if each is hugely diversified) then it is a mathematical imperative that their total returns will be differentiated by their exposure to each class and not much by the differences in individual security holdings.
Retail investors and particularly self-directed do-it-yourself retail investors do not tend to be very well diversified within each asset class. The only possible way that retail investors could be well diversified within each asset class would be to hold broad mutual funds and exchange traded funds.
Retail investors who hold individual stocks and bonds will not tend to be well diversified. It becomes preposterous to expect one retail investor who focuses on say resource stocks to have a similar portfolio return as another retail investor who holds mostly banks and utilities and such. Both may be 100% invested in stocks as an asset class, but it is preposterous to suggest that anything like 90% of their returns will be determined by the return on a broad equity index like the S&P 500.
A suggested List of Asset Classes
I don’t think there is any definitive list of asset classes or anything remotely like a definitive list. I also don’t think there is much in the way of definitive standard rules around the exposure to each asset class. And there is no definitive requirement for every investor to choose more than a couple of asset classes.
My potential list of Asset Classes is as follows:
Domestic Common Stocks – high quality and growth oriented
Domestic Common stocks – high quality and income (dividend) oriented including REITs
Domestic Common Stocks – speculative grade and growth oriented
Foreign Stocks (growth oriented only)
Domestic investment grade long-term Bonds
Domestic investment grade short-term bonds
Domestic real return bonds
Cash
Commodities (Gold, Silver)
Asset Class Timing and Rebalancing
It would be wonderful to constantly have most of your assets in the best performing asset class each year. But attempting that on a large scale defeats the risk management aspects of having a mixture of asset classes. If an investor believes that they have access to a reliable way to predict which asset classes will out-perform, then it may be worth it to slightly alter the asset allocation in that direction. However, this strategy should be limited to only moderate changes in the asset allocation in order not to destroy the risk management aspect of asset allocation.
Asset rebalancing refers to re-setting the portfolio to the target asset mix periodically. For example if stocks performed best, then some of the winnings from stocks are reallocated to the other asset classes periodically in order to prevent the stock allocation from getting much higher than the target allocation to stocks. This also provides benefits from “dollar cost averaging” since it forces investors to buy the asset class that has moved down in price and sell the class that has moved up the most in price.
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December 7, 2013
Shawn Allen, CFA, CMA, MBA, P.Eng.
President, InvestorsFriend Inc.