Fundamental Asset Class Definitions and Asset Allocation

Asset allocation (AA) focuses on managing investment risk while accepting that an investor is not likely to be able to predict what will happen next in the markets. An asset allocation plan involves choosing the asset classes that will comprise the plan and setting target percentages of the overall portfolio that should be invested in each class. Studies show that the asset class choices for an investor are the primary indicator of both performance and risk when considered over long periods of time. The actual specific investments within those asset classes are far less important. An AA plan requires periodically (typically once per year) rebalancing the portfolio as one asset class outperforms another. Rebalancing maintains the portfolio risk at a fairly constant level.

What is an asset class? The most fundamental distinction of asset classes is stocks vs. bonds.

A bond is a loan for which the investor is the lender. They are like IOUs. When a bond is purchased, the buyer is lending money to a government, company, or other organization. Interest is paid to the bond owner on a schedule specified by the bond – typically every six months. The interest rate is fixed by the terms of the bond. If the company performs astronomically well, the bond still only pays according to those terms. It does not pay more. On the other hand, bonds pay the terms of the bonds regardless of poorer than expected company performance (unless the company goes bankrupt). Investors include bonds in their portfolio to provide stability, not higher returns. For long-term investment periods, the stock market has always beaten bond performance. For periods of a decade or less, however, stable bond interest can outperform the more volatile stock market. For most investors it makes sense to have at least part of their portfolio invested in bonds. Bonds can be subdivided into multiple asset classes. A bond is classified by it’s duration, it’s risk (as determined by Moody’s or Standard and Poor’s rating system) and by country of origin. For example one bond might be an international, long-term, Moody’s Baa bond while another is a US, short-term, Moody’s Aaa bond. You can learn details about bond rating systems in Section 5.1: Wikipedia Bond Credit Rating: http://www.golio.net/Chapter5.html An asset class can also be defined using any or all of these distinctions.

Stocks are a certificate of ownership in a company. As a stockholder, you are not personally liable for company debts or mismanagement -- even if you are a shareholder of a company that goes bankrupt. On the other hand, your participation in earnings has no limit. While you can lose no more than 100% of your investment, you can earn more than 10,000% on your stock if the company is very successful. For the greater risk of owning stocks, the investor demands greater returns. This is the reason that throughout history stocks have outperformed other investments over the long term. Stocks can be further distinguished by the size of the company selling the stock. Large companies are large-cap stocks. Small companies are small-cap stocks and medium sized companies are mid-cap stocks. Stocks can be classified along a second continuum as either growth or value stocks. Using these two classifications subdivides the stock asset class into 6 other possible asset classes. When a distinction between US companies and international companies is added, we end up with 12 possible asset classes. For example a company’s stock might be an international, large-cap, value stock while another stock is a US, small-cap growth stock, etc.

An asset allocation plan can be developed based simply on the stock/bond distinction. An AA could establish a target allocation of 60% stock and 40% bond for their portfolio. A reasonable rule-of-thumb for determining stock allocation is to compute (100 – [your age]) as a target stock percentage. Thus a 40 year old would choose a 60/40 stock/bond allocation. An investor who is comfortable with more risk might use (110 – age) while a conservative investor might choose (90 – age) to compute a stock target. Such a plan isn’t complete until the investor decides how he/she will own stocks and bonds. An investor can choose to pick individual stocks and bonds through a brokerage house, or buy them through mutual funds. For an individual, diversification is most easily achieved by choosing mutual funds. A very good first order asset allocation plan could be based on only two mutual funds: 1) A broad stock market index fund, and 2) a broad bond market index fund. Historically, for periods of at least two decades, an investor with an asset allocation plan with only these two, low cost index funds would have outperformed over 80% of all other investors.

Investors may be able to improve on the above fundamental asset allocation plan by using the more refined divisions of stocks and bonds as asset class definitions. The 60% stock allocation, for example, might be broken down into 40% US stocks and 20% international stocks. Further subdivisions that consider the growth-value and/or size continuum can also be applied. Bond class definitions can similarly be applied. In addition, real estate and/or commodities can be added to the target asset classes.

Not all asset class distinctions are useful to an investor. Adding more asset classes without understanding correlations between those assets does not help a portfolio in terms of risk or reward. In other words, more asset classes is not necessarily an indicator of a more sophisticated investor.

For more on asset allocations, refer to http://www.golio.net/Chapter6.html Section 6.2.
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