One of the most fun things about managing your own investments is coming up with an asset allocation strategy to diversify your portfolio. It’s a chance to tinker like an alchemist to find that blend of asset classes that’s going to help you weather the financial storms ahead, and see you dancing upon the sunlit plains of financial independence some time yonder.
So what are the asset classes that make suitable straw for your passive investing nest?
In the rest of this post, I’ll highlight the pros and cons of the main asset classes.
This will be familiar stuff to many Monevator readers, but it’s always useful to have a frame of reference, especially as the investing world can rarely agree on a consistent definition for anything.
Filthy lucre, spondoolicks, the root of all evil… We’re all familiar with money, though perhaps not as much as we’d like to be. The simplicity and familiarity of cash is one of its biggest advantages, but excessive devotion to it can be the undoing of the cautious investor.
- You can’t suffer a capital loss.
- It’s liquid like water. If you lose your job and need some food or rent, your cash reserves can quickly be converted to satisfy whatever need is at hand.
- Cash will be clobbered by inflation over time. £100 will only be worth £74.41 in 10 years, if the ongoing inflation rate matches the historical average of around 3%. 20 years down the same timeline and £100 will only be worth £55.37.
- Historically, cash has earned the lowest returns of the major asset classes.
- Risk = Low
- Reward = Low
Cash is useful over any time frame, but you are likely to get poor slowly if you hold excessive amounts over the long term. Spicier investment options are needed to achieve most financial goals.
More on cash
Bonds are I.O.U.s issued by an entity such as a company or government. In exchange for your loan, the bond issuer will pay you a guaranteed stream of interest over the loan period, plus you’ll get your original stake back after an agreed number of years. (Unless the issuer does a Greece and defaults, that is).
Passive investors should only concern themselves with investment-grade bonds, and there are strong arguments to restrict your portfolio allocation solely to domestic government bonds.
- Government bonds are much less volatile than equities.
- Historically, they’ve provided a better return than cash.
- A lack of correlation with equities makes government bonds a useful way to protect your portfolio against stock market crashes.
- Bond returns historically lag equities.
- They are vulnerable to inflation (unless you choose index-linked varieties) and changes in interest rates.
- Many investors struggle to understand bonds.
- Risk = Lower than equities, higher than cash
- Reward = Lower than equities, higher than cash
You can match your bond holdings to any time horizon and know exactly what your return will be, if you hold the bonds until maturity.
- Government bonds i.e. UK gilts, US Treasuries
- Corporate bonds
- Inflation-protected bonds i.e. index-linked gilts, TIPS
- Local government bonds
- Junk bonds i.e. high-risk bonds with terrible credit ratings
More on bonds
Equities (commonly known as stocks or shares) are historically the riskiest and best rewarded of our main asset classes.
That relationship is writ in stone by the laws of finance. Because equities are so risky, investors demand high potential rewards to play the game. Note that word: potential. There is no guarantee that equities will deliver; they do not provide a guarantee of income or capital. Instead, they offer part-ownership of a company and thus a claim on its future earnings.
- Equities have traditionally outgunned every other asset class when it comes to long-term returns. They are the most powerful asset class in your diversified portfolio.
- Equities are capable of outstripping inflation. They’ve historically delivered a return of 5% after inflation, in the UK.
- The longer you hold equities, the better your chance of achieving your financial goals.
- Severe losses can occur at any time and frequently do. You could easily lose 30% of your capital in a single year.
- Losses can be very long-lasting. Japan is the textbook example of a market that’s failed to recover its value in over 20-years.
- The highs and lows of equity ownership can feed all kinds of irrational behaviour, from panic-selling in the face of loss to piling into a bubble market. Fear and greed rule.
- Risk = Higher than bonds, property or cash
- Reward = Higher than bonds, property or cash
The longer you can hold the better. Five years is the bare minimum, 20 years is a more comfortable stretch.
- Capitalisation e.g. Large cap, small cap
- Style e.g. Growth, value
- Geography e.g. Domestic, emerging markets, international
- Sector e.g. Technology, utilities, consumer staples
More on equities
As an investment asset class, property (or real estate) refers to commercial property that delivers returns in the shape of rent and the appreciation of building values. It doesn’t refer to your house.
Exposure to commercial property is generally achieved through real-estate investment trusts (REITS) or ETFs. Sticking all your money in a ‘buy-to-let’ concentrates rather than diversifies your holdings and is taking a big punt on the everlasting strength of the UK property market.
- Historically, the risk and rewards of property have been a halfway house between equities and bonds.
- It can be a useful diversifier, as global property returns have demonstrated a moderately low correlation to UK equity.
- Property is also likely to keep pace with the rate of inflation.
- Property bubbles can pop and inflict large losses on funds.
- Property is illiquid, which can lead to funds imposing exit restrictions on investors during periods of market stress. In other words, they can’t sell their buildings quickly if everyone wants their money back at the double.
- UK investors tend to have a rose-tinted view of property due to the strength of the home market over the last 20 years. However the asset class has historically lagged equities.
- Risk = Higher than bonds or cash, but lower than equities
- Reward = Higher than bonds or cash, but lower than equities
As per equities.
More on property
Investing in commodities is the business of speculating on the price of cows, or oil or gold. You are betting that the future price of the asset will be higher than the current price.
However, there are very few opportunities for ordinary investors to bet directly on that spot market price because few of us can actually store several million barrels of oil.
Commodity future funds thus don’t make their money from the onward march of the spot price but by trading futures and earning interest on collateral.
- Low correlation with equities may reduce portfolio risk.
- Gold is negatively correlated with equities.
- A good inflation hedge.
- No long-term source of reward for direct commodity exposure. Commodities don’t pay dividends and future returns should equal inflation.
- There is no clear evidence that investors can expect a long-term return from commodities futures either.
- The workings of commodity future funds are extremely complicated.
- Risk = Equivalent to Large Cap US equity.
- Reward = Inconsistent and hotly debated. Better thought of as a method to reduce the risk of equities.
Commodities should be thought of purely as an equity diversifier and therefore held for a similar timeframe (if at all).
- Energy e.g. oil, gas, petrol, heating oil
- Agriculture e.g. wheat, corn, soybeans, cotton, sugar, coffee, cocoa
- Industrial metals e.g. aluminium, copper, nickel, lead, zinc
- Livestock e.g. live cattle, feeder cattle, lean hogs
- Precious metals e.g. silver, gold
More on commodities
Alternative asset classes
Other asset classes exist, of course. You’ll no doubt have heard tales of the killings to be made in:
- Hedge funds
- Private equity
- Volatility e.g. the ‘Fear index’
- Collectibles e.g. art, wine, cars
A passive investor wades into these waters at their peril. Most alternative asset classes can be discounted on some or all of the following grounds:
- Their role in a diversified portfolio is highly questionable.
- They suffer from high costs, or illiquidity, or other barriers to entry/exit.
- A high degree of expertise is required to avoid being spanked by other players in the market.
- Their track record is murky at best.
The bottom line is that any investor can construct a highly diversified portfolio from the main asset classes: cash, bonds, equities and property, and also stirring in commodities if you’re truly convinced by its merits.
Take it steady,
- Note, this is the expected trade-off based upon the historical returns of each asset class. Actual risks and returns can turn out very differently. [↩]
- This isn’t an exhaustive list, just a quick run-down of the more common varieties. [↩]
- An agreement to buy or sell a commodity at a particular price, at a set date in the future. [↩]