Asset classes: one view, many ways to hold it
Sorting investments into asset classes is a useful start. What matters more is how each instrument behaves, and which one fits you.
What are the main asset classes?
You can call it sorting by asset class, by product type or by investment category. They all mean much the same thing: an attempt to make sense of the investment universe. Shares, bonds, cash, property, commodities and the funds that hold them each get a box.
The boxes are useful, but they overlap, and a clean split between them is not possible. Much of the literature on the subject shows the same thing. Forcing every instrument into one category hides how it actually behaves.
The same view, held four ways
Say you hold a positive view on gold. How could you act on it?
- Buy physical gold.
- Buy a gold exchange-traded fund, or a unit trust that invests in gold.
- Buy shares of companies that mine gold.
- Buy gold futures contracts.
It is the same view, expressed in four very different ways. A mining company carries its own business risk on top of the metal. A fund has fees and tracks the price in its own way. Futures use leverage and expire. Some of these instruments are classed as complex products, which is a good reason to understand them properly before using them.
Engineers know that malleability, ductility and hardness mean different things, even though all three describe a metal. Investment products have their own vocabulary in the same way, and it is worth learning before choosing between them.
Seven considerations, not one
Allocating between asset classes is half the work. Each instrument also has to fit the person holding it. The CFA curriculum sets out seven considerations, which I shorten to RRTTLLU:
- Return: what you need the money to earn, which is a separate question from what it might earn. Setting a required rate of return explains one way to decide it.
- Risk: how much the value can move, and how much movement you can live with. Bet size matters here as much as the choice of holding.
- Time horizon: when you will need the money.
- Tax: what applies to the instrument and to you.
- Liquidity: how easily you can get your money out, and at what cost.
- Legal and regulatory: the rules that apply to the instrument, and to you as an investor.
- Unusual or personal circumstances: everything about you that does not fit the other six.
Blending asset classes in proportions that express your view and respect your own seven considerations is what portfolio construction is about.
A third axis: monitoring effort
Risk and return are the usual two axes for comparing asset classes. I would add a third: how much attention the holding needs, and who watches it for you. A listed share can move a long way within a trading day, while some other holdings change slowly. If you will not be watching, that is part of the choice too. It is one reason who makes the final call on each trade matters as much as what is held.
Questions
What are the main asset classes?
Most guides list five: shares (equities), bonds (fixed income), cash and money-market instruments, property, and commodities. Funds and other products hold these in different mixes.
What is the difference between an asset class and an investment product?
An asset class is what you are exposed to, such as shares or bonds. A product is the wrapper you hold it in, such as a single share, an ETF, a unit trust or an investment-linked fund, and each wrapper has different costs, liquidity and monitoring effort.
Is asset allocation the same as diversification?
Not quite. Asset allocation is how you divide money between asset classes; diversification is spreading holdings within and across them so no single holding dominates.
First published on isaacfang.com on 8 August 2018 as "Risk Returns and Investment Classifications". Expanded with the considerations Isaac uses in practice; named products and providers removed. Lightly edited for this site.