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