Everything about asset classes and investment diversification

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Asset classes have no teacher and no rating system, but they are the subject of an important lesson for investors. When you know how to combine asset classes within your investment portfolio, you can tailor your risk and growth potential to your needs.

What is an asset class?

An asset class is a grouping of investments based on common behaviors, characteristics and regulations. Stocks and cash are two of the asset classes, for example. Equities have their own risk, return and liquidity profile, which is different from the risk, return and liquidity profile of cash.

Types of asset classes

Here are the four main asset classes:

  1. Cash and cash equivalents. You know what cash is – the legal tender we use to buy goods and pay off debts. Cash equivalent are investments that can easily be converted into cash. Examples include money market funds and US Treasury bills and certificates of deposit (CDs) that mature within three months.
  2. Actions. Stocks are shares of ownership in a company, also known as stocks. The value of stocks can rise or fall depending on the performance of the company, investor demand and other factors. Ideally, the value of stocks increases over time, creating returns for investors. Some shares also give rise to dividend payments.
  3. Fixed income. Fixed income securities, or bonds, are loans that are split into units and sold to investors. Investors provide the principal upfront and then receive interest payments until the security matures. At maturity, investors are reimbursed the principal. Capital doesn’t increase in value over time like a stock would, but fixed income securities should provide predictable income.
  4. Alternative investments. Alternative investments are a catch-all asset class for anything other than cash, stocks, or fixed income securities. Real estate, precious metals, cryptocurrency, and peer-to-peer lending are alternative investments.

Image source: Getty Images.

Understanding asset classes

Understanding how asset classes behave in relation to each other helps you manage the risk in your portfolio. As shown in the table below, each of the conventional asset classes offers its own level of risk and return.

Asset class

Risk of loss (Risk)

Growth potential (reward)

Cash and cash equivalents

Very slow

Very slow

Actions

High

High

Fixed income

Moo

Moo

Alternative

Varied

Varied

Table by author.

Stocks have the greatest growth potential, but what goes up can also go down. There is no free lunch, so to speak – if you want growth, you have to accept volatility.

If it weren’t for this volatility, investors could place all of their wealth in the stock market where they can generate the highest returns. But it is possible that a portfolio of stocks temporarily loses 20 or 30% of its value very quickly.

You can protect yourself from this volatility by diversifying your portfolio or by holding different asset classes alongside your stocks. Cash, fixed income and alternative assets are not directly affected by the same factors that influence the stock market.

In terms of investors, these other asset classes have a weak or negative correlation with equities. Concretely, if the stock market collapses, your cash balance will not change, nor the interest you will receive on your fixed income securities.

The importance of diversification

You can test how diversification protects you from major market fluctuations with a few simple calculations. The table below shows how four portfolios would react to a 30% drop in the S&P 500, which is a major stock index. For simplicity, these portfolios contain only cash and S&P 500 index funds.

Wallet

Portfolio value Pre-crash

Portfolio value after the crash

100% of the S&P 500 fund

$ 100,000

$ 70,000

80% of the S&P 500 fund

20% in cash

$ 100,000

$ 76,000

S&P 500 Fund at 60%

40% in cash

$ 100,000

$ 82,000

40% S&P 500 Fund

60% in cash

$ 100,000

$ 88,000

Data source for table: author’s calculations.

As you can see, the all-equity portfolio mimics the 30% drop in the market. Portfolios with cash and stocks are not as badly affected.

Of course, any buffer against market volatility always works both ways. While your diversification into cash or fixed income securities protects you from stock market crashes, it also limits your access to market growth. In short, your asset mix strongly influences the risk level of your portfolio and its growth potential.

Diversification within asset classes

You can also manage risk by diversifying within asset classes. This involves owning multiple stocks and multiple fixed income securities. You can and should be specific about this diversification for two reasons:

  1. Diversifying into stocks that share risk factors doesn’t help much. Spread your exposure across companies of different sizes that operate in different industries.
  2. You can diversify too much, to the point that each additional security reduces your growth more than it limits your risk. This is called over-diversification. You can become too diversified by owning too many individual stocks or investing in funds with overlapping portfolios.

How does diversification work?

When thinking about how to diversify your portfolio, consider the different levels of risk you face. For example:

  1. A single business can fail. The possibility that a single business could falter or fail is what investors call unsystematic risk. Business-specific issues usually arise from issues that are under management’s control, such as production, product quality, or strategic direction. If the company performs poorly, the stock price may go down. In extreme cases, the business could default on its debts and go bankrupt. You would protect yourself against unsystematic risks by owning around 20 individual stocks or bonds. You can also invest in index funds or mutual funds that hold many stocks or bonds.
  2. An industry can falter. Entire industries can also falter. Changing consumer behavior, regulatory factors and other megatrends can put pressure on all companies in an industry. For example, movie rental retail chains no longer exist, in part because customers prefer streaming over physical rentals. You would protect yourself against industry specific risks by investing in various industries, you guessed it.
  3. The whole stock market can weaken. Macroeconomic trends such as a recession or a global pandemic can limit the performance of companies in all industries and even geographies. These broader trends can lead to bear markets, stock corrections and the dreaded stock market crash. This is called systematic risk. Systematic risk is unpredictable and inevitable. You can reduce your exposure to systematic risk, but not eliminate it, by diversifying into asset classes other than stocks.

To conclude, here are some homework for you. Review what you know about these five words of investing vocabulary: asset class, correlation, diversification, unsystematic risk, and systematic risk. Then think about how to apply these concepts to your own investment portfolio. You’ll know you’ve been brilliantly successful when you are comfortable with the risk in your portfolio and excited about its growth potential.


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