How to Use Different Asset Classes in a Portfolio

When most investors think of diversification, they think of spreading their investment across several companies. There is, however, a different kind of diversification that’s equally important: asset class diversification. A wise investor balances a variety of assets to ensure risk management.

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What is asset allocation?

Asset allocation is the practice of investing in more than one asset. Many are familiar with asset classes like stocks and bonds. However, the options are more diverse. Other classes include fixed-income securities, commodities, marketable securities and real estate. In recent years technology has given rise to new alternative asset investments like the Bitcoin.

When an investor commits to an asset allocation strategy, they are attempting to bolster their returns while mitigating risk by diversifying across relatively uncorrelated products. That is, the rise and fall of commodities like gold have little influence on a real estate holding. There is some interesting research illustrating the value of this strategy.

Making it work

Researcher and writer Med Faber has examined the returns associated with a variety of asset allocation strategies. He begins with a review of the most basic asset allocation approach: a portfolio holding 60% stocks and 40% bonds. Over the long-term, this mix underperforms an equities-only style. The problem with equities-only is that it fails to mitigate risk. While the long-term results are strong, there can be prolonged periods of disastrous market downturns as was the case during the global financial crises.

In his, research Faber compares the long-term performance of several asset allocation styles. Some managers give more weighting to commodities. Others tilt towards international equities. After an exhaustive review of the numbers and nuance, Faber learned that “As long as you have some of the main ingredients – stocks, bonds, and real assets – the exact amount doesn’t really matter all that much.”

By investing in different asset classes, you avoid, in part, the problem of high valuations. That is, investing entirely in stocks may expose you to initial share prices that are too high. These unreasonable valuations make long-term gains difficult as a result of getting into the market at a high.

A few ground rules

Though most blends deliver similar returns, there are a few basic rules to follow. You must minimize costs. Faber’s research underscores this point. The similarity of strong returns among different asset class mixtures begins to deviate when costs are left unmanaged. Additionally, once an investor has selected their blend, they must commit. The game of wealth is a long one. If you change strategies, you’ll erode value with fees, taxable gains, and poor market timing.

Above all else remember that history shows committing to a single asset class over the long-term can bring catastrophic losses. If these losses occur as you’re entering retirement, you’ll have no time to recover.

As you delve deeper into the mechanics of the winning portfolios measured within KINFO, you’ll likely see that some form of asset allocation is at work. The pros can find value in nearly any asset class and with the proper analytics in KINFO so will you.

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