Friday, September 11, 2009

Asset Allocation: Part 2 – Asset Classes

Asset Allocation is kind of like putting your eggs in several baskets and giving the baskets to people who take different routes to Granny’s house. The trick is to choose high quality baskets and to choose routes so the Wolf can’t intercept more than one basket.

The value of your investment portfolio should be divided among several different asset classes. Examples of asset classes are cash (bank or money market accounts), U.S common stocks, U.S. preferred stocks, U.S. corporate bonds, U.S. government bonds, commodities, international stocks, international bonds, and real estate. This is an incomplete list but covers the classes most commonly considered and bought.

Asset class subcategories include large cap stocks (big public companies), small cap stocks (relatively small public companies), growth company stocks, value stocks, and dividend paying stocks. Subcategories frequently overlap with a single company falling into more than one category.

Asset allocation is not just diversification. Diversification refers to owning multiple stocks or bonds with the objective being to protect your wealth in the event one of the companies you are invested in becomes worthless. To be sure, asset allocation also provides the protection of diversification. The difference is that in asset allocation you intentionally invest in asset classes that tend to increase or decrease in value independently from one another.

For example, usually as the price of stocks go up the price of bonds go down. The same is true of cash and commodities – when one goes up the other normally goes down.

Nowadays, there are ways to invest in commodities and real estate through stocks, ETF’s and mutual funds so even a modest portfolio, like mine, can take advantage of asset allocation using a variety of asset classes. A sample portfolio might consist of shares in an Extended Market Mutual Fund, a Total Market Bond Fund, a REIT (Real Estate Investment Trust) Fund, and a Precious Metals Mutual Fund. The allocation percentages might be set to 25% for each class.

The sample portfolio might behave in the following ways under the specified market conditions:

1. Conditions - slow economic growth with low inflation:

a. Extended Market Mutual Fund increases slowly
b. Total Market Bond Fund is stable and paying consistent dividends
c. REIT Funds increase slowly
d. Precious Metals Mutual Fund declines slowly

2. Conditions – slow economic growth with high inflation:

a. Extended Market Mutual Fund is stable
b. Total Market Bond Fund declines
c. REIT Funds increases rapidly
d. Precious Metals Mutual Fund increases rapidly

3. Conditions – recession with low inflation

a. Extended Market Mutual Fund declines
b. Total Market Bond Fund increases
c. REIT Funds decline
d. Precious Metals Mutual Fund is stable

Ideally, one or more asset classes will go up regardless of the market conditions. By itself, this kind of an asset mix will tend to preserve the value of the portfolio protecting it from big declines and also preventing big increases. A powerful tool to improve this result is “rebalancing”.

The next post will explain portfolio rebalancing.

Links to other Topics in the Special Report: Asset Allocation

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