What Are Asset Classes?
Asset classes are a way for us to categorize - or simplify - the assets available to us as investments. Just like the rest of the world, there are an infinite way of looking at things. The first decision for most people is deciding what assets are available to them as investments. Illiquid assets such as real estate, raw land, and timber often require active management and come with material transaction costs. Commodities (like oil, corn, and gold) do not generate "cash flows" in the form of interest or dividends. They are priced using raw supply and demand dynamics. Bitcoin - and other cryptocurrencies - are not yet regulated and therefore are unavailable to institutional investors.
Just like most things in life, there are infinite ways to classify financial assets. The most basic structure is cash, bonds, and stock. Cash is - as it sounds - money tucked under a mattress or deposited into a savings account at a local bank. It can also be a money market fund at a brokerage shop that invests in 30-day Treasury bills. A bond is simply a loan to a firm (or government entity) with a contract describing how the loan will be paid back to the investor in the form of periodic interest payments and eventually the principal. A stock, on the other hand, represents an ownership stake in the firm with no guarantee that the cash outlay will ever be paid back. Despite this risk, stocks have generated strong returns to investors over a long period of time. Bonds - as a group - have delivered modest gains with lower risk than stocks over several market cycles. Cash has been the lowest risk and reward of these three major assets classes.
Why Do We Allocate Them?
The chart above shows that over a long period of time the asset class that has bounced around the most (stocks) has also reaped the biggest rewards. You might wonder: why would we invest our money into anything other than stocks? The primary answer is that past performance is no guarantee of future results. The secondary answer depends on our personal time horizon and our personal risk tolerance. The challenge for most of us is that we may not have the fortitude to lose money for several years before the odds turn in our favor and we start making money like a bandit. Many investors may be tempted to try and "time" the markets by deciphering cycles and trends. This has proven to be "fools gold" for all but a very few and this approach is ripe with emotional challenges and stories of financial ruin. The chart below shows that the correlation between a broad group of stocks (the Morningstar Total US Stock Index) and an equally broad basket of bonds (the Barclays Capital Aggregate) has bounced around pretty dramatically over the past 25 years. Correlation is a number ranging from -1 to +1 indicating how these assets tend to move in the opposite direction to each other at any one point in time (-1) or in the same direction at any one point in time (+1). This "non-stationarity" of correlations makes predictions very difficult for anyone.
How Do We Allocate Them?
One simple way to allocate between assets is to simply put an equal amount of money into each class. This is actually that way that Nobel Prize winning economist Harry Markowitz is rumored to manage his own portfolio. Another rule of thumb is to start with 100 and subtract our age. This is the percentage that might be allocated to stocks. The investor would then put the remaining portion into bonds - less 10% into cash. The beauty of this approach is that it automatically reduces an investors risk when the portfolio is adjusted to the new target percentages each year. A final idea is to "weight" the asset class percentages according to the long term relative returns. This structure helps to rein in an asset class that has recently outperformed the other two and reward one which may be poised for a rebound. The main problem with these three approaches is that they do not take into account the personal risk tolerance of an individual investor
A better way to allocate among asset classes for long term investors was outlined by Harry Markowitz in his 1952 paper titled "Portfolio Selection." He described a process using three main inputs that allows an investor to either maximize their expected return for a given level of expected risk or minimize their expected risk for a given expected return. For those of you who may still have nightmares from your math classes, this process is called calculus of variations and it is the best way to solve portfolio optimization problems. The main inputs to this problem are the expected returns, the expected risks, and the expected correlations between our three main asset classes. The return is the reward we receive for investing. The risk is the bounciness (or variation) of those returns. The chart below shows what is known as an efficient frontier of all optimized portfolios using these inputs. The small orange triangle marks the spot along the curve that might be appropriate for a moderate investor using these asset classes and this set of assumptions.
What Does This Mean?
This efficient frontier uses a mean-variance optimization engine based on the work by Harry Markowitz way back in 1952. It provides us with a graphic reference to the monotonic relationship between return and risk. Each point along the curve represents a different mix of cash, bonds, and stocks. Here is an example of the optimized allocation shown for the orange triangle mentioned above. It specifies a 57% weight to bonds and a 43% allocation to stocks. The output also shows an expected annual return of 4.3% and an expected annual risk of 8.2% - much higher than the green square above whose allocation is shown below as 100% cash. Every investor has their own unique risk tolerance and will be comfortable at a different point along the efficient frontier shown above. To complicate the problem further, this efficient frontier will change over time and it will tend to move further "Northwest" on the grid with the addition of more diverse asset classes.
What Is Next?
Nobody knows the future for certain. One of the most important lessons about investing is that it (almost) does not matter what your process is - just as long as you follow the recipe through good times and bad. I joke that our goal at JQR Capital is to be less completely wrong than most others over a long period of time. When someone tells you they know exactly what will happen and when, grab your wallet and run! Next time we will give a first glance at our security selection process. Stay tuned!