In November 2008, the scene unfolding in Peter and Olivia's living room was playing out across the country.
Peter had just gotten home from a long day of the work, and was less than pleased to find the entrance to the house that he shared with Olivia blocked by his wife, who was holding an opened envelope in her hand and looked to be a fuming mood.
"Honey, I thought we were diversified, how can all of our investments be going down so much at the same time? How can our portfolio be down 50%?"
"We are... I mean I thought we were. We own mutual funds that own like 200 stocks..."
What threw Peter and Olivia -- along with millions of other Americans -- for a loop is that they misunderstood the impact of diversification. The primary benefits of diversification occur not just among individual stocks -- which tend to trade together in times of economic distress -- but among what economists call different asset classes. This article will look at what asset classes are and then take a brief tour of the different kinds of asset classes that you can invest in to avoid suffering the fate of Peter and Olivia.
A Review of the Asset Class
If it is not precisely clear to you just what an asset class is, that is for a good reason. It isn't really to anyone else either. There is no precise definition, and it is possible to carve the financial world into anywhere from three to twenty different asset-classes depending on how encompassing and granular you want to be in your definitions.
Generally speaking, an asset class is composed of investments with similar characteristics that can be expected to behave in similar ways because of those characteristics.
For instance, you could spread an investment in the US stock market across some 5000 companies. But each of these investments shares many characteristics:
- They are all stocks, meaning they represent a claim on a company's future earnings. So they will all be sensitive to fluctuations in the economy that cause estimates of those future earnings to go up or down.
- They are all based in the US, so they will be particularly sensitive to fluctuations in the US economy.
- They are all subject to similar laws, taxes, and regulations.
- They are owned by many of the same mutual funds, pension funds, and other shareholders, so they will be sensitive to changes in the attitudes or risk tolerance of those shareholders.
These similarities can cause these investments to move together as a group, especially in times of economic distress. This is why Peter and Olivia were so surprised that diversification did not protect their portfolio more; though they were invested in hundreds of individual investments, they only had one asset class -- US stocks.
By contrast, despite originating in the same country, US Treasury Bonds have very different characteristics that cause them to operate very differently from stocks:
- They are not stocks, but bonds, meaning they represent an IOU from the US government. The size of this IOU is fixed and therefore not sensitive to changes in the economy.
- Unlike stocks, bonds are viewed as a "safe-haven" by both US investors and foreign investors, so they will often go up in times when the stock market is cratering (like 2008).
- On the other hand, bonds are very sensitive to changes in inflation, or the purchasing power of a dollar. Commodities, gold, and real estate, on the other hand, will tend to do well in inflationary environments like the 1970s.
Because investments within an asset-class tend to "move together," the mix of asset classes within a diversified portfolio is a much more significant factor in determining returns than the mix of individual assets.
In other words, while Coke may outperform Pepsi in some years, if you throw Coke into a portfolio with forty other US stocks, what really matters is not whether you own Coke or Pepsi, but what percentage of your total wealth is in the US stocks category as a whole.
A Brief Tour of Asset Classes Available to Individual Investors
While US stocks are the most familiar asset class to most investors, there are a wide variety of places to put your money. Here is one way the universe of investments may be classified.
- Domestic stocks are investments in US companies that are usually listed on the New York Stock Exchange or the NASDAQ market. US stocks are the safest investments for US citizens to hold for a couple reasons. First, the firmly established US legal system protects the rights of investors (something that cannot be taken for granted elsewhere). Second, US investors face little currency risk when investing in US companies as compared to investing in Euro or Yen-denominated investments.
- International developed-market stocks are investments in companies domiciled in countries like the United Kingdom, France, Germany, Australia, and Japan. Most of these countries also have long and established histories of capitalism, but the returns to these investments are usually in a different currency, such as the Euro or Yen. This creates the risk that US investors will lose money if that currency loses value relative to the dollar. This group may be sub-divided into European stocks and Pacific / Asian stocks.
- Emerging markets stocks are investments in companies from countries like China, India, and Brazil. Emerging markets are thought by many to have the highest potential returns as well as the highest potential risks of any stocks. In many cases, the rapidly developing countries that these companies are from do not have an established history of respecting shareholder rights. A risk is that US-based shareholders see their stakes appropriated or seized during a crisis. At the same time, many emerging countries have grown and likely will continue to grow at a much higher rate than the US economy.
Treasury Bonds are I.O.U.s from the US government. Bond holders lend out their money, for a fixed period of time. In return, they are compensated by interest payments every six months. Treasury bonds are considered "safe haven" investments for a few reasons:
- With a bond, the borrower makes a legal promise to pay back the full amount of the loan at the end of the term. With stocks, there is no such promise made.
- In the event that the issuer of a bond goes bankrupt (as was the case with Enron or Lehman Brothers...), bond holders have the first claim on the issuer's assets. They get paid back in full before other stakeholders receive anything.
- Investments in government bonds (called Treasury Bonds because they are issued by the Treasury Department) are the safest kind of bond investments because they come with the full backing of the US government, which has the authority to tax citizens of the largest economy in the world, as well as to print money in its own currency.
- Treasury Inflation Protected Bonds (TIPS) are Treasury bonds that come with built-in adjustments for inflation. TIPS pay a smaller amount than nominal Treasury bonds every year as interest, but the size of their "coupon" increases along with inflation. This makes them a key inflation hedge, and a very important piece of many portfolios.
- Real Estate Investment Trusts (REITs) are legal entities that own real estate properties like apartment buildings, malls, and office buildings. REITs make money by charging the occupants of their buildings rent every month. They pass through most of their earnings that they receive every year directly to shareholders in the REIT in the form of dividends. Because a REIT is a special entity that is required by law to distribute most of its earnings every year, it does not have to pay corporate income taxes.
- Commodities are actual, physical resources like oil, gold, and copper. Purchasing commodities outright is distinct from buying the stocks of companies that extract commodities from the ground, such as Exxon-Mobil. Investors can own pieces of funds that invest in actual commodities through an innovative new set of ETFs. These funds mimic the process of actually buying and holding physical commodities through the use of derivative transactions.
- Alternative assets like venture capital, hedge funds, and private equity are options for high wealth and sophisticated investors. These kinds of assets might move in a different way then US stocks as a whole because they are usually built on a specialized strategy or invest in private or younger companies.
It may not be necessary for your portfolio to include all of these asset classes, but the more that you include the greater the chance that something in your portfolio will go up no matter what the external environment is like.
Having built an understanding of why asset allocation is important and what assets we have the choice of allocating among, we will now start addressing the problems of which ones to invest in, starting with a look at the only free lunch in all of finance.
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