Asset Allocation Series – Part 2 – Asset Classes

1. What is Asset Allocation?
2. Asset Classes

I started my asset allocation series by defining what it is and discussing some of the key terms. In summation, asset allocation is all about diversifying your portfolio with non-correlated asset classes and rebalancing it when the asset classes stray from the desired allocation. When done properly, a well planned asset allocation strategy can increase your returns and manage your risk over a long-term investing horizon. So what are these asset classes? There are a whole lot more asset classes than just stocks and bonds.

Asset Classes

An asset class is a broad investing category. The main asset classes are stocks, bonds, real estate, cash and money market funds, gold and precious metals, commodities and collectibles. As you can see each of the main asset classes covers a very broad set of investing options. Diversifying and rebalancing your portfolio with some of the above asset classes is the first step towards achieving the benefits of asset allocation.

Subcategories

Each of the main asset classes can be broken down further into subcategories that can further enhance the benefits of asset allocation. The key is to find subcategories that have a very low correlation with the broad asset class. For example, stocks can be broken down into domestic and foreign equities. Bonds can be broken down into taxable and tax-free bonds. Real estate can be broken down into occupied properties, rental properties and commercial properties.

Styles

The subcategories can be broken down even further and classified by investing style. Stocks can be broken down into growth and value stocks. Growth stocks have higher stock prices when compared to its underlying fundamentals, whereas, value stocks have lower stock prices when compared to its underlying fundamentals. Additionally, stocks can be broken down by size. Market capitalization is the defining factor for determining the size of a stock. Stocks can be classified as large, mid, small and micro. The S&P 500 is an example of a large cap index and comprises 70% of the valuation of the total market. The bond market can be broken down similarly into two styles, investment grade and non-investment grade.

Sectors

Finally, the subcategories can be broken down into sectors. Foreign investments can be broken down by region, such as Pacific Rim and European. Emerging markets is another foreign investment sector. Bonds can be split based on the issuer, such as Treasury bonds, mortgage bonds and corporate bonds. Sectors are also defined by industry, such as energy, health care, technology and financial.

Final Thoughts

There are many asset classes that can be further broken down into subcategories, styles and sectors. All of the different asset classes, subcategories, styles and sectors provide investors with many different options for tailoring their investment portfolio to achieve a desired portfolio risk and return. Asset allocation is all about using the long-term risk and return characteristics of all of the above investment class options, as well as the correlation between the classes to determine an appropriate investment plan to meet specific goals.