In-Depth Guide to Asset Classes for True Portfolio Diversification
By: Mike Mc Mahon | Updated: February 6, 2020
Wealth is maintained and grown through proper Risk Management while investing. The core of Risk Management is diversification of assets in your portfolio. However, many do not understand true diversification through the use of different asset classes. In order to truly diversify a portfolio, it is necessary to first know what asset classes are and how they both grow and protect portfolios.
What Are Asset Classes?
An asset class is just about any group of tangible and non-tangible items of value. An asset has the ability to appreciate in value, it might reduce taxes, it could protect holdings or it might do all of these. Here, we’ll explore the four classic asset classes as well as alternative assets and exotic assets. Not all assets will fit the needs of every individual; but understanding these asset classes should help investors create a strong wealth building plan of action.
The Classic 4 Asset Classes
Stocks or equities
Traders and investors can purchase individual stocks, a variety of Exchange Traded Funds (ETF’s) and Baskets (ETB’s) or a mix of each. These are securities that can be bought and sold on the stock exchanges.
Stocks are very easily acquired and require only minimal capital to invest. One only needs to open and fund a standard brokerage account to get started, but pursuing training is advised to mitigate the risk of heavy losses.
The big risk with equities is that companies do fall out of favor due to cultural or technological changes. Additionally, they offer little leverage (the ability to control stock with less capital) when compared to Forex, futures and options. Portfolio Capitalization is also a problem as it is difficult to spread enough money into each of the 11 sectors of the market (financials, utilities, consumer discretionary, consumer staples, energy, healthcare, industrials, technology, telecom, materials and real estate) to be properly diversified and still have enough position size to generate significant profit.
When protection is the goal, ETFs/ETBs can offer that. ETFs and ETBs have become a true resource for the small or beginning investor because these buckets of stocks offer a simple way to invest in multiple stocks/sectors with one investment. These types of securities can be self-diversified, like the S&P 500 ETF called SPYders (SPY). This ETF is balanced by containing the S&P 500 Index (which itself is supposed to have the best diversification in stock). Recall, however, that stocks are only one asset class and in order to be truly diversified, it is necessary to branch out into additional types of investments.
Bonds or fixed-income instruments
US Treasury Bonds, Notes and TIPS are well known along with Municipal and Corporate Bonds. These are financial instruments where you lend the government or other agency money in exchange for interest accruals for the term of the loan.
Risks of Fixed Income Instruments
Some type of bond or fixed income investment should be in most investment portfolios. The percentage allotted to fixed income will vary with risk appetite and age. U.S. Treasuries are considered risk free as they are backed by the United States government. Nothing is actually risk free; however, these are very close to it. The downside to fixed income investments is that it takes time to reach maturity (pay off) and depending on time of purchase, the interest rates may be low. Corporate and Municipal Bonds also have the risk of suffering a bankruptcy.
Money market or cash equivalents
Bank Certificates of Deposit are the most common form of this asset class. These instruments provide for a fast cash “sweep” of money not presently working. They pay a small interest rate which can help negate the ever-present effects of inflation to some extent.
Risks of Money Market Type Accounts
Certificates of Deposit are really not investment grade instruments. They are notably short term (months to a couple of years) and typically pay a pittance in interest. At the same time, they can be useful to maintain some level of work beyond sitting in cash. There is little risk involved as there is little time in the investment or yield from it.
Real estate or other tangible assets
Single family residences are probably the biggest asset class for the general population. However, investing in other types of real estate, such as commercial properties, rental properties, and land can further diversify a portfolio. This asset class can also contain certain tangible assets like mineral rights.
Real estate is one of the more popular forms of wealth creation. By understanding people’s needs, real estate investors can leverage homes, apartments and even commercial buildings with the support of a proper team. Capitalization is less of a problem than most believe. By understanding an owner’s situation, properties can be acquired with very little out of pocket money, depending on whether the plan to is to fix and flip or to buy to rent. Knowledge in real estate is essential to investors looking to find low cost properties that have the potential for generous returns, to avoid mistakes that can eat up potential returns and to market properties effectively.
Real Estate Risk
The downside risk to real estate is that it can become illiquid, or not easily converted to cash or other cash equivalents. Then the investor must rely on rents, taxation and other means by which to hold or appreciate the value of the property.
The Alternative Asset Classes
These asset classes contain alternative methods of improving one’s ability to obtain wealth. They are designed to help protect a portfolio in times of need, to enhance income streams and to take advantage of global events.
Futures Contracts are less viable than a tangible asset, but they do allow access to virtually the whole world. They are contracts that have specific prices and expiration dates. Their chief benefit is that they offer the investor a very nice leverage – from 10:1 to even 100:1. This leverage can cut both ways, though. While it is an advantage when you are on the right side of the trade, it can also be an account wrecking ball when wrong.
Energy, grains and other food products are examples of commodities that can be traded on the futures market to further diversify a portfolio. And, Futures can also be used to hedge tangible assets.
Hedging means buying insurance for protection against loss. For example, someone who owns pork but is concerned that the price may fall might sell a futures contract for pork. As the pork price drops, the futures contract increases in value to protect their holdings. This strategy could have helped farmers during the swine flu epidemic, many of whom did not think to invest in pork until after the swine flu eradicated a number of farms.
Risks When Investing in Futures
For investors who control commodities via a futures contract, price fluctuations are the greatest risk. Remember, the leverage offered by futures can be a great benefit, but it can also increase losses if price doesn’t move as expected. Understanding the risks and being versed on strategies to reduce them is key for the trader/investor who wants to incorporate futures into their asset diversification strategy. The more leverage, the greater the potential for reward and for loss.
Precious Metals is an asset class that can be owned/controlled by physical ownership or through trading futures contracts. Gold, silver and platinum are metals that can be great hedges against the ever-present price of inflation.
Risks When Investing in Precious Metals
Precious Metals are a good fit in any portfolio because of their intrinsic value. When owning the physical asset, the risk involved is the storage and protection of a physical item that could be stolen or have a cost associated with its protection. It is also possible that the asset will decrease in price after purchase. This isn’t a concern as long as the owner is content holding onto the commodity until the price increases enough for them to at least break even on the sale. Trading precious metals carries the same risk as trading any other commodity using future contracts.
Foreign Exchange Currency
Foreign Currency Exchange (FOREX) is yet another asset class that can be used to further diversify a portfolio. Trading the Forex market allows the educated investor to take direct advantage of differing values in currencies. In other words, a trade is initiated to exchange one currency that the trader believes is going to lose value, for another currency that the trader believes is going to go up in value.
A carry trade is another possible Forex strategy. Instead of trading a currency with a lower value for a currency with a higher value, the investor relies on the countries’ overnight banking rates which have different valuations. The higher the overnight interest rate is, the more value that currency is said to have. Thus, the investor then buys the higher valued currency by selling the low valued currency. In addition to the appreciation of the position itself, the buyer is rewarded with a percentage of the difference in those interest rates.
Risk of Investing in Forex
Forex offers huge leverage to the investor, but, once again, always remember that leverage cuts both ways in terms of risk and reward. For the astute, a leverage of 50:1 could offer significant income streams to support and grow the long-term wealth bucket. Additionally, Forex tends to trend for longer periods of time than many other assets, which reduces the risk somewhat. The carry trade offers a smaller return, but position size can make this plan pay. In either case, there are extraordinary risks to be considered, such as interest rate risk, country risk, geo-political risk and others.
Options are traded on the open market using contracts between a buyer and seller. It is an incredibly versatile trading instrument that offers the ability to use leverage and the opportunity to minimize risk. While most investors would not consider Options a specific asset class to invest in, options can be used cheaply and efficiently to hedge against troubled markets.
Like Futures contracts, Options have an expiration date and settlement price. To use options, one might sell a Put Option to receive money in the form of a premium for an asset when it reaches a lower price. This is being paid to wait for the better opportunity.
Typically, a Put Option would be purchased to add a layer of damage insurance to protect the portfolio. For instance, if someone is concerned that the price of a stock they own is going to change direction, they could cheaply buy a Put Option. As the value of the stock drops, the value of the option increases, offsetting their losses. If price reverts to the good, they can attempt to sell whatever left over value the Put option may have.
Think of a put option like auto insurance. You pay a premium that affords you the protection that you want. Very few go for 100% coverage, but rather choose a deductible to make the premium cheaper. If a $500 deductible was chosen, then any damage in an amount less than $500 would come out of the pocket of the car owner. If it was a catastrophic accident, the owner would get a new car, less the $500 deductible. With a put option, though, it is possible to recoup some of the premium should the apparent danger leave the marketplace. This is done by selling the remaining intrinsic and time value back to the market.
Options Trading Risk
An Option involves some inherent risks. It certainly is money out of pocket and, being a contract, is limited in time. Also, many of the more expensive assets cause the Option to carry a large bid/ask spread which can cost extra money if not carefully handed. Many call this a wasting asset, however, especially in times of a violent drop in other markets, an option can be a good use of money.
The Exotic Asset Classes
Collectibles speak for themselves. Those who invest in Collectibles need a deep grounding in knowledge about the specific item. Coins, cars, wines, baseball cards and postage stamps are just a few of the assets that are referred to as Collectibles. In many cases, a hobby when young becomes the passion of the adult, and their knowledge of the asset grows with them over time. There are few better teachers than experience.
Art collecting has a long history. In fact, most of the world’s art museums grew out of great private collections formed by royalty, the aristocracy or the wealthy. Again, a deep education and an appreciation of the aesthetics of painting, sculpture or even ornate book bindings is required. The risks lie in fraud, improper evaluation, theft and, in most cases, high capitalization.
A Joint Venture is a business agreement between two or more parties to consolidate their resources to profitably accomplish a specific task. This task could be a new project or any other business transaction. The risks should be immediately apparent. An investor’s, money is theirs to grow or lose. A joint venture, however, requires partnering with somebody else who might not have their partner’s best interests at heart.
If capital preservation is to be the main focus of owning expanding wealth, then education is one of the best risk reducers for any portfolio. The ability to diversify amongst securities, then, begs the topic of diversification over different asset classes.
We have looked at the common, the alternative and the exotic asset classes. While they carry differing amounts of potential risk and reward, when simplified to its base, the risk for each is the same - loss of capital, and the reward is the same as well – lifestyle enrichment.
The potential for reward comes from knowledge, education, patience and practice as wealth management is a skill, not a science. It takes time and determination. Which asset classes and diversification strategies fit you the best is going to be determined by your age, upbringing, educational background and capital to work with. As has been pointed out, there is no reward without the acceptance of some risk. So, the final arbiter of your portfolio will, at least in part, be your risk appetite or aversion to it.
To learn more about diversifying investments through the use of Forex, futures and options, sign up for a free 3-hour class.
About the Author
Mike Mc Mahon
Mike Mc Mahon was a co-founder of Online Trading Academy in 1997 and was Director of Education for 13 years. He is well versed in economics and has addressed the London School of Economics and participated in the Salon de L'Analyse in France. Though officially retired, Mike fulfills his passion for sharing knowledge by remaining a member of Online Trading Academy's content team.
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