What do a Great Dane and a Toy Poodle have in common? At first glance, seemingly nothing. Side by side these two animals will look comical together. Yet we still categorize them both as dogs because, despite the dramatic difference in appearance and stature, these breeds have similar characteristics shared by all domestic canines. In the world of investing, investments that share similar characteristics are organized into groups called Asset Classes. Asset classes can appear and act as differently as the Great Dane and Toy Poodle.
How Asset Classes are Organized
Investments are typically organized in the following ways:
- By type: Equity (stocks), Fixed Income (bonds), Real Assets (commodities and real estate), or Cash
- By location: United States, International, or Emerging Markets
- Stocks by size: Large-Cap, Mid-Cap, or Small-Cap
- Stocks by style: Growth or Value
- Bonds by issuer: Corporate or Government
- Bonds by credit quality: Investment Grade or High Yield (also known as “junk bonds”)
The Rationale for Asset Classes
Most of the time, asset classes tend to not to be positively correlated with one another. For example, U.S. Large Cap Growth stocks and U.S. Investment Grade Bonds have a correlation of 0.1891. Let’s take a look at what “correlation” means and how it impacts asset classes. If you ever took a statistics class (and actually retained what you learned) you may remember that a correlation of 1.0 means that two asset classes always move in the same direction, up or down, together, whereas a correlation of 0 means that two asset classes never move up or down together. Lastly, when a correlation of -1.0 exists, it means two asset classes always move in opposite directions. Therefore, a correlation of 0.189 means that these two asset classes are distinctly different and do not necessarily move in the same direction.
Since many asset classes are distinctly different, they often react differently to news, market forces, and economic cycles. For this reason, investors should and do invest in multiple asset classes to reduce volatility. This is known as Asset Allocation: a strategy of mixing different asset classes together in a calculated manner based upon an investor’s risk and objectives to build an efficient portfolio. Picking the right investments is important, but research shows that Asset Allocation also has a significant effect on a portfolio’s risk and performance.
Asset Allocation in Action
Take a look at this chart for just a moment and try not to get dizzy. The chart shows the performance of major asset classes each year, ranked from best-performer to worst-performer. Notice that the performance of each asset class can vary dramatically from year to year. Do you see a pattern? This is a trick question because there isn’t one. If you did see a pattern, it means you are human (Apophenia is the human tendency to see patterns and meaning in random information). Predicting which asset class will do well in any given year is nearly impossible. Commodities, for example, were the worst performing asset class seven out of nine years from 2012 to 2020. In 2021 Commodities performed well due to rising inflation and so far in 2022 it is the best performing asset class. Would you have predicted that after looking at this chart?
Now, let’s look at the location of the dark blue square in each year. This dark blue square represents a balanced portfolio blending the six other asset classes in the chart. This blending of asset classes, or asset allocation, creates a balanced portfolio that is never the best performer nor the worst performer- by design. It generates strong risk-adjusted returns through a variety of economic and market environments. The balanced portfolio smooths out the roller coaster ride of each individual asset class’s performance.
Your Investment Portfolio’s Asset Allocation
Now that you have gained an understanding of this chart, you are most likely thinking, “How do I find the right asset allocation for my investment portfolio?” There is no simple, rule-of-thumb, one-size-fits-all, or cookie cutter asset allocation that can or should answer this question. Your portfolio’s asset allocation should be based upon your personal situation which includes your financial plan, objectives, time horizon, and your comfort with risk. The Wealth Advisors at GreenUp Wealth Management use sophisticated investment modeling and financial planning tools, coupled with their years of experience, to determine the best blend of asset classes and investments based upon your unique situation. You deserve a customized investment portfolio to get you to where you want to go. Please reach out to a GreenUp Wealth Management Advisor to discuss what your portfolio should look like or share this with a friend/family member for this game changing discussion to get your portfolio on track for long-term success.