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Diversifying with Asset Classes: Achieving Higher Returns while Reducing Risk

ri-blog-1-img-1Let’s discuss Asset Class Investing, a method of diversified portfolio construction that can improve your performance while reducing overall risk.

Before we look at how asset class investing works first let’s define, what’s an asset class? There are two characteristics used to define equity asset classes. The first, is the SIZE of a company and the second is the relative PRICE (or value) of the company’s stock. For example, in terms of size there large companies in the market, and there are also small companies in the market. By large companies we’re referring to their market capitalization, or “market cap” for short, which essentially measures the total market value of the company. Walmart for example is a “large cap” company. On the other hand, companies that have a smaller market capitalization are referred to as “small cap” companies. These tend to be companies that most people have never heard of.

In addition to measuring companies by their size, you can also measure companies by a second characteristic. The price or value of its stock. In this case a company can either be a “growth stock”, or “value stock”. A growth stock has a higher stock price because the company has relatively higher earnings and has “grown”. These companies are relatively heathy and well established. You can think of them as “excellent” companies, thus investors are willing to pay more for the perceived safety of these investments but should expect lower returns along with lower risk. Whereas, a value stock tends to have a lower stock price in relation to other companies in the same industry and can be perceived as “under-valued” or “distressed”. Investors generally expect to be paid for taking the additional risk of a distressed company.

So, essentially, any company you can think of will generally fall into one of these “style boxes”:

ri-blog-1-img-2There are Large Cap Value companies, Large Cap Growth companies, Small Cap Value companies, and Small Cap Growth companies. All of which are referred to as “asset classes”. These same asset classes also exist in International Developed Markets as well as Emerging Markets. Meaning you can invest in International Large and Small Caps as well as Emerging Market Large and Small Caps.

So, how do asset classes help smooth out the ride for investors wanting to capture steady market returns? The answer: these asset classes tend to not move in the same direction at the same time. So, when one asset class in your portfolio is zigging another may be zagging, thus balancing your portfolio’s performance.

That said, let’s take a look at this “periodic table of asset classes” chart of 8 major asset classes in the US, International, and Emerging Markets over the last 10 years ending Dec 2012.

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This chart ranks each asset class’s annual performance, from highest to lowest, in each column year-by-year, with the best performer on top and the lowest performer at the bottom.

ri-blog-1-img-4Each asset class has been given a different color to emphasize an important point – in both the US and non-US markets there is little predictability in asset class performance from one year to the next. You never know which asset class will outperform from year to year, and attempting to predict which one will be next year’s winner is a guessing game. For example, there are cases where the best performing asset class in one year became the lowest performing asset class the next year, such as the highest performing Emerging Market Small Cap in 2007 because the lowest performer in 2008.

ri-blog-1-img-5Conversely, there were years when the worst performing asset class in one year became the best performer the next year. For example US Small Cap Value was the lowest performer in 2007, then became the highest performer in 2008. The same thing occurred with Emerging Market Small Cap in 2008 and 2009, and also 2011 and 2012. However, this is not always the case, as we can see in 2003 US Large Cap Growth was the lowest performer, and continued to be the lowest performer in 2004. During those same two years International Small Cap was the best performer two years in a row. The point is performance of any given individual asset class is difficult to predict.

So, how can you improve your odds of holding the best performers while lowering the volatility in your portfolio? The answer: own all of them! By owning all these asset classes in a diversified portfolio you are positioned to capture the best returns in the market wherever they occur!

To demonstrate this point let’s take another look at the chart, but let’s add one more box. A black box representing a blended mix of all these asset classes together, by simply evenly weighting all…

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Notice how the performance of the Blended Mix appears more stable and has less volatility than any single asset class year-by-year. By combining all these asset classes together into a diversified portfolio you smooth out the ride, which helps you stay invested in the equity markets. Best of all, not only was the Blended Mix less volatile, but its annualized performance averaged 11.9%, over this 10 year period, while the S&P 500 Index, which most investors fail to beat, averaged 7.1% over the same period.

So what does this mean to you? Well, there’s good news and there’s bad news. The bad news is nobody knows which asset class will be next year’s winner. The good news is you don’t need to be able to predict the future to be a successful investor, if you own them all!


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