What Asset Classes Are Right for Me?
Everyone hears that you need to “diversify,” but a lot of people don’t really understand what that means. To really be diversified, your investments must come from different asset classes. They must also complement other investment-like aspects of your life like your career or your spouse’s career.
As a general rule, you should have money allocated to fixed-income assets, equity assets and highly liquid cash assets. Fixed-income assets provide steady, scheduled payments. Equity assets are riskier but have historically provided higher returns. Cash provides flexibility to spend money or to invest more in other asset classes, regardless of how the market is doing.
It is foolish to try to pick a “winner” among asset classes. While specialization works well in your career, it doesn’t work very well for building a portfolio.
Your asset allocation should be personalized based on these elements of your life:
Time horizon. This is the time between when you are investing and when you will need to spend money to meet your financial goals. The longer the time horizon, the larger the percentage of your portfolio you can allocate to risky equity-type assets.
Outside assets. Your house, pension income, your job, your spouse’s job, pending inheritance and business ventures are all possible sources of cash in the future. For instance, you could sell a house or share of a business to raise cash. Alternatively, employment is likely source of cash in the future. Your asset allocation should complement these external assets, not mimic them. For example, if you work as a Realtor® own your home and own a vacation home, you should allocate less of your investment to stocks and trusts that focus on real estate. Since real estate is an equity investment and being a Realtor® is a highly cyclical job, you should also have less assets invested in equity assets in general. Conversely, a tenured government employee’s salary behaves like a bond, so government employees should underweight fixed-income assets.
Risk tolerance. Before the 2008 financial crisis, financial advisors would try to assess the psychological risk tolerance of investors and mesh this with their ability to take on risk before advocating a portfolio. This is nonsense, because most investors did not understand how taking a huge loss feels. They felt betrayed by Wall Street, because they didn’t understand that such outcomes were possible. When you think “risk” you should think “loss.” We want to avoid risk, regardless of romantic notions about risk taking and adventure. A better, more sensible approach to risk tolerance is to assess how much extra money or time you have to meet your goals. The more time and money you have to meet your goals, the more risk you can afford. People who have much more money than they need can afford to take on more risks than people who have little to spare.
Exchange-Traded Funds for Asset Allocation
The best Exchange-Traded Funds (ETFs) are the ones that allow you to invest across entire asset classes with low fees. When you invest into a broad market, you can buy a share of an investment that goes upward and downward in value based on the relative value of an entire market. So, if a few companies do poorly, you barely notice it. If the entire market does poorly, you have the opportunity to buy more shares of an ETF. Since there are stock ETFs, bond ETFs, commodity ETFs and even real estate ETFs, you can diversify to an incredible extent. This way, you can have a lot of protection against the downsides of a few companies while you enjoy the general upward trends of the markets as a whole.
But, you also need to remember fees. While stocks have flaws, one of their strengths is that there is no recurring fee to own a share of stock. As well, bonds don’t charge you fees. However, most mutual funds and ETFs do charge some kind of fee for holding them. The good news is that you can avoid most of the fees by selecting low-cost ETFs. In some cases, you will be paying less than half of 1% of the value of the ETFs you own, which often have returns in the 6–8% range. The lower your costs, the better you can do.
A lot of people are obsessed with trying to “beat the market” by trying to pick tomorrow’s winning investments and asset classes. Unfortunately, this kind of thinking tends to result in failure far more often than not. The best way to grow your wealth and keep your network safe is through diversification. The easiest way to invest, and the one that has worked for many investors, is to simply invest in broad market ETFs.
Jim’s Asset Allocation
Jim invests through his discount brokerage and through his employer’s 401(k) account program. Jim also owns a home with a mortgage and works as a salesman at a car dealership. Mary, Jim’s customer service representative, calls him and asks him to sit down. Mary wants him to change his older asset allocation to a new one. She shows him his current account holdings with the brokerage, which includes:
$50,000 in foreign stocks through low-fee ETFs $50,000 in municipal bonds
$30,000 in cash and six-month CDs
Mary said, “Your account has too much cash and too much bond investment for such a young guy! You’re 40, and you should be in equities.” She thinks that since Jim is still working (he is 40 at this time), he should have more of his portfolio invested in stock. She suggests that he sells $30,000 of his municipal bonds and $30,000 of his foreign-stock ETFs and invests $80,000 total (including $20,000 from his cash) in a mutual fund that covers world stock with a 2.0% fee.
Jim told Mary that his discount brokerage account was only part of his net worth. He explained that he has a separate 401(k) account sponsored through his company which includes:
$50,000 in commodities through low-fee ETFs in his 401(k) account
$100,000 in company stock offered to Jim by the company at a 25% discount
$50,000 in corporate bonds through low-fee ETFs in his 401(k) account
Jim also told Mary that he owns a home with a $250,000 market value and a $100,000 mortgage balance.
Mary listened quietly but didn’t write this information down. She said, “Your other assets won’t factor into your account here, Jim. You don’t have enough stock here.”
Fortunately, Jim understood the value of considering investments based on the value they add to an entire portfolio. He said, “Mary, my other assets matter to me, your client. We should do what makes the most sense for me overall.” He explained to her that the equity in his house, his company stock and his commodity holdings have similar risk characteristics to the mutual fund she recommended. He said, “If you think about everything, I have $300,000 in stocks, real estate and commodities but only $130,000 in cash and bonds. I think I might have too much in ownership kinds of assets and not enough in fixed income.”
Jim was right. As a car salesman, his career, or human capital, follows the stock market. When the economy is fairing well, more people buy cars. When the stock market is down, fewer people buy cars. Jim’s income is based largely on commission from these sales and highly depends on market risk. For this reason, Jim should be invested more in fixed-income assets than in stocks and other ownership investments that are sensitive to market risk.
The conversation continued and Jim discovered that Mary earns a commission from her clients’ mutual fund holdings but not from cash or bonds. As Jim contributed more savings to his investments, he favored bonds and asked Mary to keep an eye out for bond mutual funds and exchange-traded funds with low fees.