Asset Allocation 101: What are the Asset Classes and How Does One Choose?

Most investors know that stock prices fluctuate. So do bond prices, option prices, real estate prices, and cheeseburger prices. Even discount warehouse membership prices fluctuate (yes, even when prices only go up, if they do so occasionally and unpredictably, that’s fluctuation).

This is why many financial professionals preach diversification in asset allocation. The aim of a diversified portfolio is to have some portfolio components zig while others may be zagging.

Asset Allocation: What’s the Big Deal?

It’s important to give your portfolio allocation some careful thought, as it could impact your long-term risk-adjusted returns. The mix of assets you choose generally determines your portfolio’s volatility (how it performs under different market conditions).

So what are your choices when you diversify? In other words, what is an asset class? Most investors begin with stocks and bonds, but did you know there are other asset classes to consider? Plus, some investments combine elements of more than one asset class, in what’s called “multi-asset" investments.

There are lots of subdivisions and categories, but remember that on a portfolio level, the differences between assets are important. So buying two (or three or even 10) high-flying Internet stocks, for example, would not be considered diversification. 

Equities, aka Stocks

If you’re seeking the potential for growth or saving for retirement, you might put a percentage of your assets in stocks, which represent partial ownership of publicly held companies. Stocks tend to be riskier than some of the other asset classes and have historically performed well over long periods of time. Remember, past performance is no guarantee of future results.  

Within the equities asset class, there are many subdivisions:

• Sectors. There are currently 11 stock sectors, including technology, financials, energy, consumer discretionary, and so on. And each sector can be divided into subsectors.
• Size. Companies come in all sizes, from multinational conglomerates to small startups, and all points in between. The capitalization (size) of a company is determined by the value of the company, defined by shares outstanding multiplied by the daily stock price. Some funds concentrate on large-caps, others on small- or mid-caps.
• Objective. Some stocks are priced for growth; others for value. Some pay high dividends; some plow all profits back into the business.
• Geography. Some professionals suggest a mixture of domestic and international stocks as part of a diversified portfolio.

Choosing how much of your portfolio to put in equities might be one of the most important decisions in asset class selection. One general rule of thumb is to subtract your age from 110 and invest that percentage in equities. For example, if you’re age 50, you might consider putting 60% of your money in equities (110–50=60). Of course, each investor should consider their personal circumstances to decide the appropriate allocation.

Fixed Income, aka Bonds

If asset classes had a “big two," the fixed income asset class might be the second, along with equities. In fact, many investors build a diversified portfolio using just equities and fixed income. While stocks offer the potential for growth, bonds offer the potential for income, making them an appealing investment choice for people nearing retirement or those who have a more conservative investment style.

Bonds offer a set rate of interest and their value varies based on key risk factors: time to maturity (longer is riskier) and creditworthiness of borrower (the U.S. government is assumed to be safer than an over-leveraged startup).

Just as with stocks, you can choose bonds from different sectors, capitalizations, and geographies. But each comes with different risks. For example, international bonds might expose you to foreign exchange risk.

How much of your money should you put in bonds? If you use the 110 rule from above, you might consider putting the majority of your non-equity dollars in fixed income. 

Looking for Alternatives? Here’s an Entire Asset Class

Depending on your goals, time horizon, and risk tolerance, alternative asset classes such as real estate or commodities might also make sense for your portfolio.

Real Estate

Real estate is an important asset, not least because everyone needs a roof over their head. If you own a house, technically you’re a real estate investor. But if you rent an apartment, you are also involved in real estate, because the cost of your place will vary as the value of real estate changes. So, in a sense, every family has exposure to this asset class. It can be in the form of your primary residence, rental or investment property, or in shares of publicly traded real estate investment trusts (REITs).

For many years, many investors viewed this asset class as having stable values and stable returns, but the events of the last decade’s banking and real estate crisis reminded investors of the risks involved in real estate investing. For many families, owning a home might be enough real estate exposure. But using REITs within the context of the equity allocation might be appropriate for you.

Commodities

Commodities are the raw materials that get made into other things. Crude oil, grains, livestock, and metals—these are commodities. While they may not have the panache of, say, Internet stocks, they can be an important portfolio component.

There is great debate, however, as to how to invest in commodities as an asset class. Some professionals argue that buying the stocks of steel producers or oil drillers is sufficient, while others argue that having some exposure to actual steel or oil is the best way to get diversified exposure. There’s no simple answer here, so some research and evaluation of the pros and cons is in order.

Cash: Yes, It’s an Asset Class

Cash and “cash equivalents" typically include checking and savings accounts, money market funds, and other investments with short-term maturities of three months or less. Cash may be boring, but it can also be safe. For savings that will be used soon, within the next several years, this can often be a consideration for some investors. Plus, many budget planners suggest keeping three to six months’ worth of living expenses in an emergency fund. And from an investment standpoint, it might make sense to have some “dry powder" in case an investment opportunity should come along. But keep in mind that although cash doesn’t technically lose value, its purchasing power tends to decline over time as inflation makes goods and services more expensive.

Multi-Asset: The All-In-One Choice

Rather than create your own asset allocation, you might consider a multi-asset mutual fund or exchange-traded fund. As the name implies, this type of investment consists of a predetermined mix of the asset classes described above. And you can select the one whose allocation aligns with your goals. For example, depending on your time horizon, you might invest in a multi-asset fund that’s more heavily weighted in stocks over bonds, or vice versa.

Investing is a series of steps with each one building on the one before it. Understanding the different asset classes is the first step. From there, you can decide which ones you want to use and how to allocate your money among them to create a diversified portfolio to pursue your goals.