Introduction

An asset is a financial instrument that earns dividends or interest or that appreciates in price. An asset class is a group of assets with similar risk and return characteristics. Asset classes can be broadly defined, such as equities and fixed income. Asset classes can also be more narrowly defined such as large and small company stocks or short and long term bonds. Asset classes can be defined by geography (e.g. United States, developed countries, and emerging markets). Sometimes, asset classes are defined by their growth potential (i.e. growth v value).

In order to build a diversified portfolio, you must first select asset classes that have minimal correlation with one another. In finance, correlation measures the changes of two variables over time. Two coin tosses are completely uncorrelated. In investing, you won’t find completely uncorrelated asset classes. Nevertheless, you should strive to minimize asset class correlation so as to increase your portfolio’s risk/return ratio.

David Swenson, the Chief Investment Officer at Yale University, presents one of the best overviews of core and non-core asset classes for individual investors in Unconventional Success: a Fundamental Approach to Personal Investment.12. As Swenson admits, asset class definitions can be subjective because they assume “precise distinctions where none exist” in reality. It is difficult to forecast risk and asset correlations. You can use historical data as a guide but there will always be both anomalous economic periods, and structural changes in particular industries. Moreover, quantitative models may fail to predict “significant, low-probability events” and market illiquidity.3

Here, we will focus on the core asset classes that are recommended for individual investors.

Core Asset Classes

Swenson defines a core asset class as follows:

1. It contributes “basic, valuable, differentiable characteristics to an investor’s portfolio”
2. It relies fundamentally on markets, not active management to generated returns,
3. It trades in “broad, deep, investable markets”

Because individual investors should only invest in large, liquid, heavily researched markets, the only asset classes that you should focus on are stocks, bonds, and real estate:4

• Stocks drive your portfolio returns
• Fixed income (bonds) provide protection from financial catastrophe associated with stock volatility
• Real estate, with hybrid equity and bond attributes, provides inflation protection more cost-effectively than other alternatives

U.S. Equities

Jeremy Siegel, Professor of Finance at the Wharton School of the University of Pennsylvania, notes that over the long term, stocks out-perform all other asset classes. Stocks also provide the best protection against unexpected inflation over the long term.5 6 But, stocks also have relatively high volatility.

Shareholders and company management tend to have aligned interests: revenue and earnings growth.7

Stocks carry an equity risk premium because stock gains and dividends are not guaranteed. Stockholders generally stand last in line behind bondholders and other creditors. Stocks are volatile compared to bonds. It is possible to lose a significant percentage of your equity assets. Individual stocks may have no value if the underlying company goes bankrupt or out of business. To address the volatility of individual equities, individual investors should own an “all inclusive, market-like portfolio of equities securities” as part of a well-diversified portfolio.

As of 2019, the real returns of stocks are 3.5%. That is the sum of a 2% dividend plus a 1.5% growth rate. The standard deviation of U.S. Equities is ______%.

Historically, investors considered the S&P 500 synonymous with the U.S. stock market. The S&P 500 includes the 500 largest companies in the U.S. by market capitalization.

Foreign Developed Equities

Equity in developed foreign countries should generate similar expected returns as U.S. equities. The similarity of labor, goods, and services across countries leads investors to expect comparable long-term results.

But, foreign developed equities differs from domestic equities in two ways:

1. Different countries are subject to different economic conditions. The lack of correlation between foreign market and U.S. market economic conditions means foreign developed equities provide portfolio diversification. However, globalization increasingly has linked foreign and domestic markets. As economic factors ripple across borders and multinational companies dominate US and foreign markets, correlation has increased between domestic and foreign developed equities.
2. U.S. investors are subjected to foreign currency fluctuations. Academics have determined that foreign currency exposure up to a quarter of your portfolio reduces risk. However, foreign currency exposure over a quarter of your portfolio increases risk.

Bear in mind that foreign company shareholders and company management are less closely aligned than U.S. companies. Profit generation may not be the sole focus of foreign company management. Other considerations may include a company’s workers, lenders, and the community.

As of 2019, the real returns of foreign stocks are 4.5%. That includes a 3% yield plus a 1.5% growth rate. Their risk is _____%.

Emerging Markets Equities

Emerging markets represent higher risk, higher return investment opportunities. Emerging markets are neither developed nor undeveloped. Don’t confuse an emerging country’s growth with strong equity market returns.

Emerging market companies may have far less alignment between shareholders and company management. Emerging market governments and family-controlled companies’ interests may diverge from those of their shareholders. Capital controls, governmental regulations, and a lack of transparency may similarly harm investors.

As of 2019, the real returns of emerging market stocks are ____%. That includes a ___% yield plus a ____% growth rate. Emerging markets equities have a standard deviation of ____%

U.S. Treasury Bonds

Treasury bonds are backed by the full-faith-and-credit of the U.S. Government. They are presumed to be free from the risk of default. During financial crises, U.S. Treasury bonds provide the greatest degree of portfolio protection. They also serve as a hedge for unexpected deflation. Moreover, Treasury bonds are the most liquid asset in the world.

Treasury bonds are sensitive to interest rate fluctuations. This means that longer term Treasury bonds are riskier than short term bonds due to potential unexpected inflation. Actual after-inflation returns on long-term bonds may differ significantly from anticipated returns. Although the income stream remains fixed, the purchasing power of that income stream will be reduced by unexpected inflation.

Compared to corporate bonds, U.S. Treasury bonds have strong alignment of interests. U.S. Treasury bonds issued after 1984 are not callable. This is both because the majority of U.S. Treasury bonds are owned by federal, state, and local governments and U.S. taxpayers and because the U.S. government does not want to harm future access to credit markets.8

Due to the fact that US Treasury bonds are the least risky and most liquid investment, they also carry the lowest return. For this reason, individual investors should make only a modest allocation to US Treasury bonds.

As of 2019, the real returns of U.S. Treasury bonds are 1.4%. Their risk is _____%.

U.S. Treasury Inflation-Index Securities (TIPS)

At maturity, U.S. Treasury Inflation-Protected Securities (TIPS) pay the greater of the original face value or the inflation-adjusted principal. This provides investors with both deflationary and inflationary protection. Like U.S. Treasury bonds, TIPS are presumed to be default-risk free and not callable.

As of 2019, the real returns of TIPS are 1.4%.  Their risk is _____%.

Real Estate (REITS)

Real estate investment trust returns provide significant protection against inflation. Their risks and returns have qualities like both equity and fixed income investments. Vacant properties or properties with short- term leases are more equity-like. Their market value responds rapidly to inflation. Properties with long term leases (and therefore consistent income streams) have bond-like characteristics. Due to the long term leases, these properties have little correlation with inflation.

There is a strong relationship between the replacement cost and the market value of real estate assets.9. When the market value of real estate exceeds its replacement cost, income yield (rent) rises and nearby economic development is stimulated. When the replacement cost of a property exceeds the market value of real estate, income yield falls. Real estate investors then buy existing properties rather than building new ones.

REIT investors should expect returns 2.5% above government bonds. But, the quality and cost of REIT funds vary significantly. You should seek a highly diversified and liquid fund with low fees and few conflicts of interests.

As of 2019, the real returns of REITS are ____%. REITS have a standard deviation of ____%.

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Updated on January 29th, 2019