This is part 4 of 7 in a series designed to help you be a do-it-yourself portfolio manager. Part 1 discussed goal-setting, part 2 discussed the relationship between your portfolio’s return and how much you need to save. Part 3 introduced the concept of choosing asset classes. This post will continue that concept and list some of the asset classes you might want to consider in your portfolio. There are dozens of asset classes. You cannot, nor should you include all of them in a portfolio. I have divided the asset classes into various categories, including cash, fixed income, domestic equity, international equity, commodities, and alternatives.
Mattress Money – This is money you keep in the house or in the safe deposit box. It is physical money you can pick up on your way out of town after a natural disaster. It might be a stack of $20 bills, rolls of quarters, or even gold coins. It might be denominated in US dollars, Pounds, Euros, or even Yen. It’s probably worthwhile to have some of this as part of your emergency fund, but the expected real return on this asset is precisely the opposite of the inflation rate. Savings account/Checking account/Money Market account – This is money at the bank. Not as accessible as mattress money, but at least it earns a little bit of a return. That return is generally no more than inflation (especially after-tax) and currently is quite a bit less than inflation. But it is safe and quite liquid and generally covered by FDIC insurance. Money Market Funds – This is a mutual fund which strives to maintain a value of $1 per share (usually successfully.) There is no FDIC insurance, but historically it has been able to offer slightly higher yields than bank accounts. Currently that isn’t really true. The money is safe and quite liquid as asset classes go. CDs – Rules vary by the bank, but you can usually get to this money pretty easily, although you usually lose some interest if you withdraw it early. The money is FDIC insured, and generally earns more than a typical savings rate, especially for longer terms. Fixed Income Treasury bills – Very safe, very cash-like short term (less than a year) loans to the US government. Historically has barely beat inflation before taxes. Treasury bonds – Loans to the US government for longer periods of time, up to 30 years. Principal value can swing significantly with interest rate changes, but still considered quite a safe investment. Returns generally best inflation by a small amount.
Corporate bonds – Loans to businesses. In addition to interest rate risk, you also run default risk. Since these are riskier than treasuries, the return is usually slightly higher. Can be split up into various subclasses by term and by default risk. Higher risk corporate bonds are known as junk bonds.
Foreign government bonds – Similar to treasuries, except you also run currency risk (if the dollar rises in comparison to the currency your bond is denominated in, you lose money.) Obviously, some governments are more likely to default than others.
Foreign corporate bonds – Similar to domestic corporate bonds, but with currency risk. Some mutual funds hedge against that risk to virtually eliminate it, but at the cost of a lower expected return.
Inflation-indexed bonds – In the US, these include TIPS and I bonds. Basically, you are guaranteed a real return, and the bond covers any unexpected inflation. Foreign governments and even some corporations also issue these. Returns should theoretically be lower than comparable nominal bonds, but haven’t been for reasons that aren’t completely clear.
Peer to Peer Lending – A relatively new phenomenon where you invest in consumer loans to individuals. Initial returns are promising, but the risk of default can be ridiculously high. Liquidity and time required to manage the investment is also a concern.
Mortgage-backed securities – These bonds are composed of loans to homeowners for their mortgages. There are other types of asset-backed securities, but these are the most common.
Slice and Dice Asset Classes – Morningstar developed a 9 box way to view the equity markets, dividing stocks by size (large, mid, and small) as well as on the value/growth continuum (value, blend, growth.) This provides nine asset classes from large cap growth to small cap value. All 9 of these asset classes have their pluses and minuses and can be reasonably included in a portfolio, although some experts have argued that small growth should be avoided due to a “lottery effect.”
Sector Asset Classes – The US economy (and thus stock market) is frequently divided into numerous sectors, including financials, technology, energy, health care etc. There are at least 11 of these.
REITs- Although traded on the stock market, many investors feel REITs are fundamentally different enough from other stocks that they can be considered a different asset class, and not just a sector. Many popular static portfolios (such as Yale and Coffeehouse) include a separate slice of REITs in them.
Precious Metals Equities – These are companies that mine gold, silver, platinum etc. Considered by some, such as William Bernstein, as a separate asset class.
Microcaps – Many, such as Rick Ferri, consider microcaps a separate asset class. These are the smallest stocks that are publically traded on the stock market. Theoretical returns are promising. Actual returns can be disappointing as it turns out this is a hard class to invest in well.
Over the counter stocks – These are stocks of tiny companies that aren’t big enough to be listed on a stock exchange and must be bought and sold on “pink sheets.” There are significant issues with investing in this asset class (especially transparency and a high prevalence of scams), and it should probably be avoided by most physician investors.
Returns of most of these asset classes are generally expected to significantly outpace inflation, but with significant volatility and risk of temporary and permanent loss.
All of the asset classes listed above in domestic equity could be recreated in every country in the world, producing hundreds of “asset classes.” (Think Brazilian microcap health care stocks.) But in general, when people talk about international equity asset classes, they refer to these:
Developed Markets – This generally encompasses stocks in Europe, Japan, Australia, New Zealand, and other countries with highly developed economies. As you would expect, it can be subdivided by market capitalization and on the value/growth continuum.
Emerging Markets – This asset class is composed of stocks that are in economies that are still developing. Brazil, China, India, Russia and dozens of other countries. The higher risks of investing in these economies give this asset class a higher expected return than domestic or developed stocks.
Frontier Markets – Want more risk? Why not invest in the Middle East and Africa? There are such serious issues involved in investing in most of these countries that it makes Emerging Markets investments look relatively tame.
International REITs – Vanguard has a relatively new fund that allows for this asset class.
International value stocks and international small stocks are commonly held asset classes also.
Precious metals – This includes gold, silver, copper, platinum etc. Many investors hold one or all of these in their portfolio. The expected long-term return is inflation, minus expenses, but with its low correlation to other asset classes (and purported value as apocalyptic money), it is held by many. It can be held as metal in your possession, metal in someone else’s possession, and in a half dozen other manners, all with their pluses and minuses. Gold, in particular, tends to have long periods with disappointing returns and short bursts of outstanding returns.
Energy – You can invest in oil, gas, natural gas, uranium, coal and even alternative energy directly, buy futures contracts on them, buy the stocks of companies that produce, refine, or transport them, buy wells, or even go into partnerships (MLPs) to invest in them. There are pluses and minuses to each of these, and some promising expected returns due to taking significant risk and enduring impressive volatility. Those people aren’t living in North Dakota for the weather.
Agricultural commodities – You can “invest” in anything from corn to wheat to “pork bellies” to cocoa. Some suggest funds of collateral commodities futures have a place in the portfolio. Expected returns are near inflation, so the case for adding these to a long-term portfolio are primarily based on low correlations with more traditional asset classes such as stocks and bonds. Of course, there are a lot of speculators in commodities.
Non-precious metals – Steel, aluminum, copper etc. Similar issues to agricultural commodities
Direct Real Estate Investments – Whether speculating on land, buying apartment buildings, or renting out your old house, there is potential for big profits (especially when combined with leverage) in this asset class. One downside is that it is very hard to rebalance (and even regularly value) these investments.
Currencies – You can speculate on changes in currencies using various instruments. The expected real return is negative after costs.
Larry Swedroe, in his excellent The Only Guide to Alternative Investments You’ll Ever Need lists 20 different alternative asset classes. The book is well worth a read before delving into any of these. I won’t go into that much detail in my list.
Financial Products – This includes life insurance, annuities, options, futures, structured investments, preferred stock (a combination of a corporate stock and a corporate bond), covered calls, convertible bonds and other derivatives. Each of these options has potential, but the products tend to be complex, and complexity almost always favors the issuer over the investor.
Private Equity – Many companies aren’t owned publicly and traded on the stock market. That doesn’t mean they’re not good companies. It can be a difficult asset class to invest in, often requiring high minimums and “knowing somebody.” Several recent articles have suggested returns aren’t quite as good as many thought in the past. There is obviously less transparency than in the public markets.
Hedge Funds – Ahh, the rich man’s investment. There are a dozen different types of hedge funds out there. Their recent popularity has seriously diluted the talent. The question is whether there was ever significant enough talent to make up for the ridiculously high fees. Probably an area for most to avoid when it comes to designing a simple portfolio.
Collectibles – Yup, if you’d have bought the Mona Lisa a couple of hundred years ago you’d be doing pretty well. Not exactly a mainstream investment product. This category includes everything from art to Beanie Babies to baseball cards. Generally a hobby, not an investment.
There are more asset classes than you can shake a stick at. You obviously don’t need most of them. In part 3 we discussed how to choose which ones to include in your portfolio. In part 5 we’ll discuss how to allocate between them to form an asset allocation.
Photo Credit: Brett Weinstein, CC-BY-SA, via Wikimedia Commons