An Overview of Broad Asset Classes
Now that you understand the importance of asset allocation, and how to estimate the target real rate of return you’ll need to earn to reach your accumulation goals, let's take a closer look at the different broadly-defined asset classes you can include in a portfolio.
There are many criteria that can be used to define different asset classes. For example, one might be the type of claim involved (e.g., debt or equity); another might be whether the organizations on which a claim is made in the pubic or private sector (e.g., government or corporate bonds); and a third might be where these organizations are located (e.g., domestic or foreign government bonds).
At a still deeper level, asset classes can be defined in terms of the mix of exposure they provide to the principal drivers of investment returns, whether these factors are defined statistically (e.g., via principal component analysis) or in terms of factors that are more intuitively meaningful to investors, including, for example, economic growth, changes in consumer prices, investor herding, monetary policy, illiquidity, and various types of uncertainty.
However, in comparison to the type of claim, organization, or location, this factor-based approach to asset class definition gets quite tricky in practice, as over time the influence of these factors on returns tends to wax and wane. In normal times, the influence of multiple factors can be relatively balanced; however, in times of crisis, just one or two (e.g., uncertainty and illiquidity) can have a heavily disproportionate impact on financial asset returns.
Given this, we prefer to take the traditional approach to defining broad asset classes on the basis of differences in the type of the claims, nature of the obligor, and location of the asset. Ideally, these distinctions should yield asset classes that represent substantially different investor exposures to underlying return generating processes and risk characteristics, and, most of the time, to the mix of deeper factors that drive them. As a test, in the past we have only added new asset classes to our model portfolios if their average correlation of returns with the existing asset classes was below a .65 threshold.
We will now move on to more specific discussion of broad debt and equity asset classes, and then move on to commercial property, commodities, and, while not asset classes, active management strategies that are intended to produce returns that have a low correlation with those on broad asset classes.
Next Up: Debt Asset Classes