What is Asset Class Investing?
Investors can invest for growth, income or preservation. The three asset classes that fit this bill are stocks, bonds and cash - stocks for growth, bonds for income, and cash for preservation. Since 1926, stocks have returned 10.2%, bonds 5.5%, and cash 3.4%. Inflation during this same time frame has averaged 2.9%.
Stocks can be further subdivided into large, small, or international companies. Bonds can be issued by governments, municipalities, or corporations. Each of these asset classes have their own unique qualities and characteristics.
Active money managers will try outperforming a benchmark by selecting investments they deem superior to the general population. In addition, they’ll try to time their trading based on market and economic conditions. Some market watchers categorize active money management as aggressive or speculative. This style of money management is expensive as they tend to trade more often and employ analyst, traders, and other support staff. It’s also well documented that most active fund managers fail to outperform their corresponding benchmark or index.
Passive money managers purchase the underlying index regardless of valuation or external forces. An index manager won’t try to time the market and will hold their securities through all types of market conditions and cycles. The most popular index is the Standard & Poor’s 500 and since 1926 it has generated an average annual return of 10.2%. Managers who follow this index will own all 500 stocks and when Standard & Poor’s makes an adjustment to their index, fund managers will alter their portfolio accordingly. This investment strategy is rigid and doesn’t allow for much flexibility because the fund managers can’t afford to deviate from the index, also known as tracking error. Since there is little trading and no need for a large internal research team, the fees are low.
Asset class investing is based on academic research and it allows for more flexibility than the other strategies. Like passive investing, the fees are low, and diversification is high. Since trading is flexible, it’s more tax efficient than the active management style.
Dimensional Fund Advisors applies factors to their asset class investing.[1] This strategy is based on the findings and research of Eugene F. Fama and Kenneth R. French.[2] The outperformance of the Fama-French factors is over time and they are as follows:
1. Equity premium: Stocks outperform bonds.
2. Small cap premium: Small companies outperform large companies.
3. Value premium: Value stocks outperform growth stocks.
4. Profitability premium: High profitability companies outperform low profitability ones.
5. Term premium: Longer term bonds outperform shorter term bonds.
6. Credit premium: Lower credit bonds outperform higher credit bonds.
Allocating your dollars across several asset classes is what makes this strategy popular. The chart below is often referred to as a financial periodical chart, skittles chart, or quilt and this one is provided by Ben Carlson at a Wealth of Common Sense.[3] As you can see, asset classes aren’t static, and they fluctuate often. For example, if you follow the emerging market sector in the yellow box, you’ll notice it’s either near the top or the bottom. In 2017 it was the top performing sector gaining 37.3% while this year it’s near the bottom with a loss of 1.57%.
Investors who don’t adhere to an asset class investing style get frustrated with underperforming sectors and sell them at, or near, the bottom before they rebound. Small cap stocks underperformed in 2014 and 2015 before claiming the top spot in 2016. Likewise, investors will chase returns by pouring money into the hot sector usually before it rolls over like they did with commodities in 2009 and 2010.
A friend of mine who works for one of the largest mutual fund companies in the world told me the unwritten rule for his firm is for employees to invest their bonuses in the worst performing equity fund they manage from the prior year because they know it will eventually rebound.
I, too, like allocating dollars to underperforming sectors because they’ll eventually return to favor. Another advantage of buying a down and out sector is that you’ll buy in at bargain prices, a classic buy low and sell high scenario. An unloved sector also offers tremendous value to the buy and hold investor.
In a model driven portfolio that diversifies dollars across several asset classes, you can take advantage of down and out sectors by rebalancing your account annually. When it rebalances, the model will sell overpriced assets and buy underpriced ones. This strategy will keep your original asset allocation and risk tolerance intact.
A model driven, asset class portfolio offers many benefits. You get access to thousands of securities across the globe buy owning low-cost, efficient mutual funds. Furthermore, you no longer must stress about finding the right stock at the right time, nor do you have to fret about market timing. What could be better than a stress free, low-cost, model driven portfolio?
June 11, 2018
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Bill Parrott is the President and CEO of Parrott Wealth Management firm located in Austin, Texas. Parrott Wealth Management is a fee-only, fiduciary, registered investment advisor firm. Our goal is to remove complexity, confusion, and worry from the investment and financial planning process.
Note: Investments are not guaranteed and do involve risk. Your returns may differ than those posted in this blog.
[1] Dimensional Fund Advisors – Dimensions of Returns.
[2] https://www8.gsb.columbia.edu/programs/sites/programs/files/finance/Fina..., Eugene Fama and Kenneth French, March 2014.
[3] http://awealthofcommonsense.com/2018/01/updating-my-favorite-performance..., Ben Carlson, 1/14/2018.