Different Asset Classes – Part I

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This is the first in a series of articles on asset classes. Whether you are an individual managing a portfolio for retirement or someone who has just sold their business and is developing a strategy for investing funds, the choice of asset classes will be the most fundamental investment decision you will make. in the design of your portfolio.

In our M&A activity, we’ve come across many business owners who choose not to sell their business because they don’t think they can get decent returns. Often, they keep their business longer than the risks associated with age would justify. Others may not be so advanced in age but would rather sell their business and enjoy life but cannot bring themselves to sell their business because they are not confident in their ability to create a portfolio that generates a decent return. Over the past few years, there have been many articles about how we find ourselves in a “low yield” environment. The good news is that it should be possible to create a portfolio that provides a decent return over the long term.

Once you have accumulated capital, however modest it may be, put your capital to work!

This first article in the series is designed to provide an overview on the subject of different asset classes; subsequent articles will give more details on each individual asset class, e.g. bonds, stocks, real estate, luxury goods, etc.

The choice of asset classes is not a one-time decision. The decision should ideally be adapted to each portfolio:

  • Your return expectations (what kind of return do you need to achieve your goals, for example, a satisfying retirement nest egg?)
  • Your investment time horizon (for example, how long before retirement?),
  • Your risk profile (how much risk can you tolerate in your portfolio?),
  • Liquidity (how much cash could you need during your investment time horizon?)
  • The tax regime you are subject to (what is the tax rate for different investments in your jurisdiction?). This can influence the composition of the portfolio.

You need to be diversified both in terms of asset classes and investments within each asset class.

Building the ideal portfolio, taking into account your personal situation, as we hope this article and this series will show you, is a complex task, requiring in-depth experience and knowledge of the various investment alternatives. Choosing an investment advisor could be a step to consider. Unfortunately, the barriers to entry into the wealth management profession are low; in addition, some investment firms earn third-party commissions (for example, in addition to the client’s commissions) when placing clients in different investments. This is an obvious conflict of interest. If you choose an investment advisor, choose carefully!

Over the long term, your decision to allocate your portfolio across different asset classes will likely have a greater impact on overall portfolio performance than your choice of individual investments in each asset class.

There is no single definition of asset classes. Most experts will include at least three asset classes in designing a portfolio:

  • Shares or shares
  • Fixed income securities or bonds
  • Cash or near-cash

For more sophisticated clients with larger portfolios, one can also add one or more additional asset classes:

  • Real estate
  • Commodities (sometimes emphasizing gold – see my previous gold series)
  • Luxury goods (especially art)

In our series, we intend to address at least all of the above. We won’t discuss other alternative asset classes such as cryptocurrencies (e.g. bitcoin), nor private equity, which usually requires a large equity ticket. For the purposes of this series, we will use the classification shown in Appendix 1, which includes six different asset classes.

Part 1: Key asset classes

For the rest of this article, we will analyze the allocation to asset classes from the angle (A) of liquidity; (B) risk/reward ratios;

(A) Liquidity

You must always have sufficient cash or cash equivalents to cover expenses and contingencies (eg hospitalization) in the short and medium term.

According to the Society of Actuaries, liquidity is a measure of how quickly you can sell something without affecting the price.[1]. Real estate and cash are on opposite sides of the illiquid-liquid spectrum (please see Appendix 2). Real estate investments and alternative investments often have a lower level of liquidity due to their nature, they are real and tangible assets. It may take several months to sell such assets at an acceptable price. On the other hand, certain types of real assets and other tangible assets may arguably be less volatile than financial assets (bonds and stocks), and therefore can be used to balance a portfolio.

Part 2: Illiquid-liquid spectrum

Please note that the classification above is very general and, as with French verbs, there are exceptions to every rule. For example, some infrequently traded stocks may be significantly less liquid than gold coins. Shares of private companies (e.g. not listed on a stock exchange) are extremely illiquid! In most cases even less liquid than real estate!

(B) Reward-risk ratio

There is a general principle in finance that risk and return are directly proportional. In other words, the higher the return, the higher the associated risk. According to the efficient market hypothesis, one of the most fundamental tenets of finance is that all known information about a particular stock or investment is already priced into that stock or investment.

There has been a decades-long debate in finance about whether the efficient market hypothesis really applies. My personal feeling is that it provides general guidance, but investors tend to follow each other – you could call it the “lemming effect”. Therefore, bull markets (as well as bear markets) can tend to self-perpetuate.

Occasionally, there may also be an “outlier” that the market is missing, or barriers to entry create an outlier. For example, in 2001, one of the authors of this article invested in land in Hungary located 2 km from the Austrian border. Equivalent land across the border was trading at 8 times the price per hectare, potentially offering a very high return, as prices converge with Austrian land prices, with very little downside risk. (The land was sold in 2013 at more than 10 times the purchase price). Granted, these types of “outliers” cannot be found every day.

Assets could be divided into two main categories:

  • Growth assets generally present higher risk with higher potential return
  • Defensive assets generally have lower risk with lower return potential

Most asset classes can be both growth and defensive. For example, Facebook (NASDAQ:FB) and Amazon (NASDAQ:AMZN) are growth stocks, whereas a preferred stock on a stable utility would likely be defensive. Growth stocks typically have little or no dividends, generating returns from price appreciation, while defensive stocks often have higher yields, with less potential for price appreciation.

The following appendix establishes a general relationship between risk and reward:

Part 3: Risk and return characteristics of the asset class

Again, the above exposure should be taken with a large grain of salt. For example, does a Real Estate Investment Trust (REIT) have more of the risk/return characteristics of real estate or stocks?

The following three charts show indicative rates of return over the past 1, 10 and 20 years for different asset classes:

Exhibit 4: Total returns of different asset classes for 2018, %[2]

Exhibit 5: Compound annual growth rate for different asset classes over 10 years, %[3]

Exhibit 6: Compound annual growth rate for different asset classes over 20 years, %[4]

As can be seen, asset class returns vary significantly over the decades. This is one of the reasons why diversification between asset classes is so important.

Subsequent articles in this series on asset classes will be structured as follows:

  • Market sizes and trading volumes for different asset classes
  • Debt as an asset class
  • Stocks as an asset class
  • Luxury as an asset class

[1] Society of Actuaries. Invest in illiquid assets

[2] ICE 3-Month US Treasury Bond Index, S&P US Treasury Bond Index, Bloomberg Barclays US Bond Aggregate Bond Index, MSCI US, EAFE (Europe, Australasia, Far East) and Emerging Markets Indices, Bloomberg Commodity Index, Price Gold LBMA, Knight Frank’s Luxury Investment Index

[3] Same

[4] ICE 3-Month US Treasury Bond Index, S&P US Treasury Bond Index, Bloomberg Barclays US Bond Aggregate Bond Index, MSCI US, EAFE (Europe, Australasia, Far East) and Emerging Markets Indices, Bloomberg Commodity Index, Price LBMA gold

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