August 1, 2014

What Asset Classes Should I Consider for My Asset Allocation Portfolio?

When you are ready to begin investing with a disciplined asset allocation plan, you may wonder which asset classes are appropriate for your strategy.  According to the Securities and Exchange Commission, the best way to determine the best asset class is to consider two factors – your time horizon and your risk profile.

Your Time Horizon: Certain investments and asset classes are only appropriate if you have a long-time horizon of 10 years or more.  Others are only rational if you want to park money safely and securely for the next few months.  That’s because, generally speaking, the higher the potential return an asset class generates, the longer it must be held to overcome the risk of owning that asset class. For instance, history has shown that long-term ownership of common stocks is the single best way to generate real, after-inflation wealth for your family.

Yet, if you happened to invest the year before the Great Depression or another market crash, you would have temporarily seen 80% losses in your portfolio.  By continuing to invest through dollar cost averaging and reinvested dividends, you would have completely recovered within only a few years, despite the market still being down by nearly 50% because your “fresh” capital would have lowered your overall cost basis.  Within 20 years, your returns would have been breathtaking – put plainly, you’d be rich.  You’d have no problem living off your dividend income without touching your principal.  If you had been saving your money for a down payment on a house, you’d have been destroyed because you would have experienced 80% losses and been forced out at the bottom of the market.

Your Risk Tolerance: Investing is not purely rational.  As much as it pains me to say it, most investors simply don’t have what it takes to grow their money because they cannot stand periods of under performance, which are inevitable.  Everyone wants a stock that goes up, and only up.  They don’t want to spend thirty years buying real estate because the debt makes them nervous, or buying shares of blue chip stocks that will almost certainly be higher in ten years because they may fall in value by 50% tomorrow.  If you don’t have what it takes to watch your holdings drop in half overnight, knowing full well that a good asset allocation plan will carry you to your goals, you shouldn’t be investing at all.

The reality is that you don’t have the emotional strength or fortitude to achieve your objectives.  Save yourself the stress, save your adviser the trouble of dealing with a problem client, and just park your money in bonds for the rest of your life.  (You probably don’t realize that bonds fluctuate just as much as stocks due to bond duration and interest rate risk because it’s difficult to check bond quotes daily, unlike stocks.  But that’s okay – in your mind, ignorance is bliss.)

Asset Classes By Time Horizon

  • Stock as an Asset Class: Stocks are appropriate for only the long-term asset class portion of your asset allocation strategy.  You should never invest money in stocks if there is any chance you will need it within the next five years.  Despite generating attractive long-term gains, blue chip large capitalization stocks have actually lost money in 1 out of 3 years.  Those with a short time horizon cannot afford to take the risk of hitting a bad run because they don’t have time for the asset to recover.
  • Bonds as an Asset Class: Bonds are unique in that they can be structured to be an appropriate short-term, medium-term, or long-term asset class, making them an integral part of any asset allocation program.  For instance, savings bonds can’t be cashed for at least one year and if you cash them in prior to five years, you lose 3 months of interest income, but you are guaranteed to never lose money.  For those who need absolutely safety of principal but don’t think they’ll need the money for a couple of years, savings bonds can be a terrific choice. On the opposite end of the spectrum, you can invest in 30-year bonds from companies such as Johnson & Johnson or Coca-Cola.  These bonds have high bond duration, meaning they are extremely sensitive to interest rate changes.  If rates increase, the bond values will crash, just like stocks.
  • Cash as an Asset Class: Long-term, cash always loses real value because politicians drive inflation through the printing of money.  There are some ways to get around this by investing in FDIC insured checking accounts or savings accounts that pay interest at an after-tax rate at least comparable to changes in the consumer price index (CPI), but cash isn’t meant to be an investment.  Instead, it is a store of value; a place where you can park capital until you need it for expenses, as an emergency reserve, or to fund long-term investments.
    Asset Classes for Asset Allocation

  • Real Estate as an Asset Class: Real estate can be a great way to build long-term wealth and offers a great addition to most asset allocation plans.  Yet, real estate requires years to build equity through both property appreciation and mortgage amortization.  There are also a lot of frictional expenses involved with buying and selling real estate (title fees, inspection reports, broker commissions, etc.) that make rapid trading less appealing unless you own a company that lets you access these services wholesale. That makes real estate only appropriate as a long-term asset class.
  • Private Business as an Asset Class: Private businesses, whether you own the company outright such as a small business or have a private equity investment, companies take time to generate value.  As the years go by, earnings, assets, and shareholder equity all increase under wise and prudent management.  You can then sell your ownership and make a ton of money.  That doesn’t happen overnight.  At the minimum, a good equity investment can take 5 years to produce fruit, with 10 years far more common.