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Asset Classes and Allocation Planning

Assets are the things we buy, hold, and sell as investments. There are many types of assets, each with unique characteristics, correlations, and risks. Before you can plan your asset allocation, it is important to understand the various asset classes so you can choose the right investments when the time comes.

Understanding Asset Groups

Most portfolios contain the same basic assets: equities, bonds, cash, and other asset classes such as Real Estate Investment Trusts. Equities include stocks, mutual funds, index funds, and stocks from international countries. Bonds include savings bonds, municipal bonds, and corporate bonds. Cash is essential in the retirement phase or your life to have money you can draw on without having to liquidate or sell assets. Finally, investments in Real Estate Investment Trusts, owning real estate, or other assets such as precious metals complete a typical portfolio. Understanding each of these asset classes is essential to building a solid portfolio.

Cash Equivalent Assets

Cash may be king, but it also offers no protection against inflation or long term growth potential. Money markets and savings accounts provide liquid access to cash and will not lose any of your investment, but bonds and equities will offer much higher returns over time.

Savings Accounts & Money Markets

Savings accounts and money market accounts provide very liquid methods of savings, but typically at reduced rates. For the best rates, you will typically need to open an online savings account. While these accounts are great for an emergency fund or daily spending, the limited interest rates does not make an ideal candidate for retirement or long term investing. While you are guaranteed a positive return, that return may not pass the rate of inflation, leaving you with less buying power over time.

Certificates of Deposit

Certificates of Deposit allow you to lock in an interest rate for the interval of the CD. If rates may go down, purchasing a CD at a higher rate may make sense. For long term investments, CD laddering allows you to take advantage of long term rates while protecting you against missing potential short term increases in interest. Like savings and money market accounts, the rates of CDs are typically low, but are more likely to exceed inflation that cash accounts.

Bond Asset Classes

Bonds can be broken down into corporate, municipal, and savings bonds. Bonds are typically safer investments than equities, but offer lower returns.

Corporate Bonds

Corporate bonds are issued by companies to raise money for whatever reason. Bonds come in short, intermediate, and long terms and the quality of the bond can be determined by an assigned value (such as A). Short term bonds offer the highest returns, but also a higher level of risk. Since a bond is essentially a loan, a company could potentially default and leave an investor burned. Bonds can be purchased individually or bought in mutual and index funds. Some people like to chase poor quality bonds ("junk bonds") in hope of making a lot on a small investment, but typically you get what you pay for.

Municipal Bonds

Local municipalities offer bonds much like a corporation would. The money is used for funding projects and floating the debt to investors. Unlike corporate bonds, the governmental nature of municipal bonds lowers the risks associated with them, but it is still potentially possible for a municipality to go bankrupt and default on a bond. Municipal bonds can be purchased from the municipality or in mutual funds from brokers.

Government Savings Bonds

Government savings bonds (such as Series I or Series EE bonds) are common savings vehicles offered by the Treasury Department. The offerings tend to change over the years, but savings bonds are typically long term investments with fair interest rates. Savings bonds typically have tax advantages over other investments and have virtually no risk of defaulting. Savings bonds are offered at most retail banks and are available directly from the Treasury Department by mail or online. Some employers also offer a paycheck deduction program to purchase bonds automatically and frequently pre-tax.

Equity Asset Classes

Equities make up the bulk of most investors' portfolios. Stocks, mutual funds, index funds, REITs, international funds, and precious metals all fall into this category. Equities carry more risk than either cash equivalent or bonds, but offer higher returns on average as well.

Individual Stocks

Since a stock share is part of a company, there are many ways to group stocks together to reflect the type of company they represent. The two most used ways to represent a stock are based on the size of the company and whether the company is undervalued or growing. Putting these two measurements together forms a 9-block box that stocks can fall into. Bonds, REITs, and other non-equity assets will not fall into a block while mutual and index funds may cover more than one block in the box. When developing an asset allocation plan, it is important to not only diversify sectors that equities fall into, but also the size and value of the companies.

Mutual Funds

Mutual Funds are groups of individual stocks brought under one roof based on some factor determined by the manager of the fund. Mutual Funds may cover specific markets, geographical locations, company size, or any other feature that can group individual companies together. Because there are many companies in one fund, mutual funds are more diversified than holding individual stocks, but they are still made up of equities and are subject to market volatility just like individual stocks. Mutual funds run the risk of market timing by either trying to outwit the market or constantly chasing this years “hot new fund” that is experiencing a lucky streak.

Index funds

Index funds are specialized mutual funds that try to match a specific market index. A Total Stock Market Index may try to match the growth of the entire stock market. An S&P index fund would try to match the S&P 500 index, which tracks specific companies. Index Funds exist for all types of market types and sectors. Because index funds are made up of stocks, they still maintain the risks of equities, but they are inherently diversified because they match an index composed of many individual companies. It is still possible to overweight a sector of the stock market with index funds, so it is important to carefully plan which portions of the market your index funds cover.

Real Estate Investment Trusts and Other Assets

REIT funds, precious metals, emerging markets, and other specialized asset classes focus on investments that don't necessarily fit anywhere else. While the total stock market index funds available have small portions of REIT assets, many people will buy a specific fund to give that asset more weight. These assets often show no correlation to the stock market and also show widely diverse returns. Real estate and precious metals do help diversify a portfolio and are found in many asset allocation plans.


Next: Developing an Asset Allocation
Page last modified 3/21/2012