Investors are often told to diversify their portfolios using different categories of investments to achieve this objective. And while the concept of diversification can be explained in terms that are easy to understand- don’t put all of your eggs in one basket- how to structure a portfolio of multiple assets with different risk and return characteristics can be confusing. To demystify this medley of investments, take some time to familiarize yourself with the characteristics of the five most commonly utilized asset classes. Understanding how each one works in isolation can help you to create a portfolio that behaves like a symphony, and not a garage band.
Simply put, an asset class is made up of various securities that have similar characteristics. These include their level of risk and expected return, how they are regulated and how they are expected to behave in response to economic and market events. Each asset class is unique and some, such as FDIC-insured cash deposits, may have little in common with more volatile asset classes. There are five main asset classes: equities, fixed income, cash and their equivalent, real estate and commodities. Within each main category is a dizzying array of potential subcategories, based on their size, industry, maturity, underlying investments or location, among others.
A share of stock represents proportional ownership of a company that has offered these shares for sale on a stock exchange. Not all companies issue stocks that can be traded on an exchange, including many large and successful firms that chose to remain under private control. Stocks are often issued as a means to raise capital to fund future expansion or for the owners or other investors to realize value from their investment. Shares can be bought either directly from the company when first issued (initial public offering), or post issue on a stock exchange. Stockholders have the right to participate in shareholder meetings, receive dividends and sell their shares to another investor. This diffusion and easy transfer of ownership allow the firm to operate in perpetuity and creates incentives for the firm to hire and retain professional managers, and transition to new management when the need arises.
Stocks can be classified by the size of the firm (small, middle and large capitalization), the extent to which future earnings are likely to come from capital appreciation or income (growth or value) and whether the firm is domiciled in the United States or abroad (domestic or foreign). Companies with a large market capitalization generally have a strong market presence in their industry, while mid and small capitalization firms have lower revenues and market share. A growth stock tends to be associated with firms that are expected to increase their market share, and the firm’s revenues are expected to grow in the process. Expanding firms tend to retain earnings to reinvest in the firm. In contrast, value stocks tend to have more stable revenues and pay a higher portion of these to their shareholders by way of dividends.
When purchasing stocks, investors must determine if the price they are asked to pay is fair. While there is no foolproof way to accomplish this, investors may rely on ratios of a stock’s price to its earnings (P/E ratio), among others, projected growth in key metrics such as earnings or sales, and the firm’s dividend yield or expected growth in the earnings paid to the investor. In fact, there are thousands of valuation metrics, limited only by your imagination and tolerance for number crunching. There are devotees to growth and value investing but rarely is it an all or nothing proposition. A sound asset allocation should consider the attributes of each category and determine an appropriate mix based on factors such as risk tolerance, expected holding period, the tax treatment of the account (taxable, tax-deferred, tax-free), and the composition of other assets.
Fixed income investors enter into an arrangement with an entity that agrees to make one or more payments in return for an up-front commitment of capital. For the sake of simplicity, think of it as an IOU. Bonds are one example and are issued by sovereign and corporate entities. They generally pay a series of payments (coupons) in exchange for the use of the funds and the return of the investor’s original deposit at maturity. Fixed income is also a broad category and contains several iterations based on factors such as the length of time to the loan’s maturity, the creditworthiness of the borrower, whether income is paid over time or at maturity, and whether and how the income received is taxed.
The price paid for a fixed income investment is predicated on a somewhat different set of factors including interest rates and the risk of default by the borrower. Because these factors are different, and because the timing of the income and principal payments are generally known in advance, these investments tend to possess different risk and return characteristics than equities. As such, introducing these investments to a portfolio can help reduce the portfolio’s overall level of risk. In addition, fixed income investments may be used to provide reliable income streams to investors, and those investors in high-tax brackets may find that the tax-adjusted yield offered by a Treasury or municipal bond is favorable to that of a nominally higher but fully taxable one offered by a corporate bond.
Investors with a long time horizon may prefer bonds with higher coupon payments and a longer period of time until the loan matures. These investors may benefit from higher interest payments over time, but risk a loss in the bond’s value if prevailing interest rates increase, reducing the value of the future income payments paid by their bond. Conversely, those with shorter time horizons and the need for reliable income may be willing to accept lower coupon payments in exchange for limited interest rate or default risk.
As with equities, an investor’s fixed income allocation should consider their risk tolerance, expected holding period, the tax treatment of the account, but should also include the tax treatment of the bond and the individual’s personal tax situation.
Cash and cash equivalents:
Cash and cash equivalents are the foundation of a short-term asset allocation. Cash and other highly liquid vehicles such as checking, savings, and money market accounts allow investors to access the full value of their funds quickly without concerns for fluctuations in their value. In return for their low risk, these investments offer little return. Nonetheless, their value can be found in facilitating transactions (checking account) and providing for immediate liquidity when needed. Investors should maintain adequate emergency savings to protect against unforeseen expenses or a job loss and may wish to keep additional cash on hand to fund expenses or a major purchase that is expected to occur within a short period of time. Some examples of cash equivalents include checking and savings accounts and money market instruments.
Real estate investments may be based on residential or commercial real estate that is located inside or outside of the United States. Investors may own the underlying property or a fractional interest, and the property may be owned directly or in a variety of different entities. In a simple example, an investor may purchase one or more properties, rent them to tenants in return for ongoing rent payments and earn a tidy sum based on these rent payments, future price appreciation and the tax benefits found in depreciating the value of the property over time.
As an alternative, investors can reap some of the benefits that real estate offers without the need to part with large sums of cash, collect rent checks or tend to a broken hot water heater at 2AM. A Real Estate Investment Trust (REIT) is a company that owns and operates income-producing property. They may or may not be traded on a stock exchange and offer investors the opportunity to invest in real estate without the responsibilities of direct ownership. Publicly traded REITs offer liquidity provisions similar to equities (non-traded REITs do not) and must pay 90% of taxable income to shareholders each year in the form of a dividend. As a result, REITs can be very useful to investors seeking a high level of current income from their investment portfolio.
Direct ownership and non-traded REITs lack the liquidity of a publically-traded REIT, and investors in the latter should be particularly mindful of redemption restrictions and management fees. Publically-traded REITs are subject to price fluctuations and may not perform well in rising interest rate environments. In addition, the dividends paid by a REIT are taxed as ordinary income, unlike dividends paid by some equity investments that are taxed as capital gains.
A commodity is a raw material that is either consumed or used to create other products. There are a variety of commodities traded on global markets, including oil and gas, agricultural products and precious metals such as gold and silver.
Like real estate, investors can purchase commodities directly or through the use of futures contracts or exchange-traded products that invest in a specific commodity index. These are generally highly volatile investments and best utilized by sophisticated investors.
Investors may also purchase commodities through vehicles such as mutual funds or exchange traded fund (ETF) that invest in commodity-related businesses. There is a variety of ETFs that invest in specific sectors such as energy, basic materials or precious metals. Investing in commodities can provide a buffer against inflation, but have generally had lackluster performance in periods of lower inflation with substantially higher volatility than stocks. Still, commodities can play a role in a well-diversified portfolio for investors with a long time horizon.
Putting it all together:
Armed with an overview of asset classes, investors may construct their own portfolio, or hire someone to do it for them. Portfolio construction should consider one’s time horizon, risk tolerance and financial goals.
One’s time horizon and when the funds will be needed is a critical consideration in asset allocation. A long time horizon allows you to hold your investments through multiple market cycles and may make you more willing to accept short-term market gyrations. This principle is evidenced in so-called target-date retirement funds, where young investors are given an aggressive mix of equity investments that gradually adjusts over time to include more fixed income positions as retirement draws closer.
Risk tolerance for some, however, may remain relatively static over time, regardless of their time horizon. Each investor reacts to uncertainty and financial loss differently, and their level of risk aversion may be impacted by age, level of wealth and a variety of other factors that cannot be quantified. Young but risk-averse investors may benefit from stepping outside of their comfort zone to invest assets earmarked for retirement more aggressively than they otherwise might. Conversely, older investors that rely on their portfolio for income, but are relatively untroubled by the movements in the stock market (yes, such people do exist) should consider adjusting their portfolio’s risk, even if they’re otherwise not inclined to do so.
The use of these asset classes in a diversified portfolio can help reduce the risks associated with holding a small number of investments. Finding the optimal mix of investments based on a given level of risk is the foundation behind Modern Portfolio Theory, and is widely used by investment professionals. Whether sticking to the original five or incorporating new asset classes such as managed futures, private equity, venture capital, hedge funds, or even Cryptocurrencies, the purposes of the asset class is to facilitate the categorization of various investments so that they may be used in constructing a portfolio that maximizes risk-adjusted investment returns and helps facilitate your overall financial planning goals.