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Different Asset Classes: Part I

In the first of a series of articles on asset classes, Les Nemethy and Sergey Glekov look at the choices available for building an investment portfolio.

Whether you are an individual managing a portfolio for retirement, or someone who just sold their business and is devising a strategy to invest funds, the choice of asset classes will be the most fundamental investment decision you make in designing your portfolio.

The choice of asset classes should ideally be tailored to:

•    Your return expectations (what kind of a return do you need to achieve goals, for example, a satisfactory retirement nest egg?)

•    Your investment time horizon (e.g. how long to retirement?),

•    Your risk profile (what degree of risk can you tolerate in your portfolio?),

•    Liquidity (how much cash might you need during your investment time horizon?)

•    The tax regime to which you are subject (what is the tax rate on different investments in your jurisdiction?).

You should be diversified both in terms of asset classes, as well as investments within each asset class.

Constructing the ideal portfolio for your personal situation is a complex matter, requiring extensive experience and knowledge of various investment alternatives. Choosing an investment advisor might be a step worth considering. Unfortunately, barriers to entry in the wealth management profession are low; furthermore, some investment firms receive third party commissions when they place clients into different investments. This is an obvious conflict of interest. If you choose an investment advisor, choose carefully.

In the long-run, your decision of how to spread your portfolio over different asset classes will probably have a higher impact on overall portfolio return than your choice of individual investments within each asset class.

Most experts will include at least three areas in designing a portfolio:

•    Stocks or equities

•    Fixed income or bonds

•    Cash or cash equivalents

For more sophisticated clients with larger portfolios, one or more additional asset classes might be added:

•    Real estate

•    Commodities (sometimes emphasizing gold, see our earlier series)

•    Luxury goods (particularly art, but also cars and wine, etc.)

We intend to at least touch on all of the above. We will not deal with other alternative asset classes such as crypto-currencies, nor with private equity. For the remainder of this article, we will analyze asset class allocation from the perspective of (a) liquidity; (b) risk return ratios.

Liquidity

You should always have enough cash or cash equivalents on hand to cover expenses and contingencies (e.g. hospitalization) in the short- to medium-term.

According to the Society of Actuaries, liquidity is a measure of how quickly you can sell something without impacting the price. Real estate and cash lie at opposite ends of the illiquid-liquid spectrum (see illustration above).

Real estate investments and alternative investments often have a lower level of liquidity because of their nature; they     are real, tangible assets. It can take     many months to sell such assets at acceptable price. On the other hand, certain types of real and other tangible assets may arguably be less volatile than financial assets (bonds and stocks), hence may serve to balance a portfolio.

Please note that there are exceptions     to every rule. Certain rarely traded stocks may be considerably less liquid than gold coin. Shares in private companies (e.g. not listed on a stock exchange) are, in most cases, even less liquid than real estate.

Risk-return Ratio

There is a general principle in finance that the higher the return, the higher the associated risk. According to the efficient market hypothesis, one of the most fundamental principals of finance, is that all information known about a particular stock or investment is already built into the price of that stock or investment.

There has been a multi-decade raging debate in finance about whether the efficient market hypothesis really applies. My own feeling is that it provides general guidance, but there is a tendency for investors to follow each other; you might call it the “lemming effect”. Hence there may be a tendency for bull markets (as well as bear markets) to perpetuate themselves.

One might subdivide assets into two main categories:

•    Growth assets generally have higher risk with higher return potential

•    Defensive assets generally have lower risk with lower return potential

Most asset classes can be both growth or defensive. For example, Facebook and Amazon are growth stocks, whereas a preferred share on a stable utility would probably be defensive. Growth stocks typically have no or low dividends, generating returns from price appreciation, whereas defensive stocks often have higher yields, with less potential for price appreciation.

Subsequent articles in this series on asset classes will look at:

•    Size of markets and trading volumes for different asset classes

•    Equity as an asset class

•    Debt as an asset class

•    Luxury goods as an asset class

Disclaimer: This article is intended for informational purposes only, and should not be relied upon for investment advice. It is important to do your own investigation and analysis before making any investments based on your own personal circumstances.

Les Nemethy is CEO of Euro-Phoenix (www.europhoenix.com), a Central European corporate finance firm, author of Business Exit Planning (www.businessexitplanningbook.com) and a former president of the American Chamber of Commerce in Hungary.