We looked at how understanding our risk tolerance and setting goals is the first stage of investing in a previous post. What do we do once we understand our risk tolerance and the goals are set? The next step is to have a basic idea of the investing universe and determine the areas to put investment dollars to work.
Many individual investors have a typical journey when it comes to investing. We would have started with savings accounts or CDs and then moved to dabbling in stocks and bonds. It is also very likely that many were forced to manage our retirement portfolios when we started working and got introduced to mutual funds and index funds. Along the way, some may have got exposed to real estate, commodities, or derivatives.
In essence, many individual investors do not have the opportunity to look at their portfolio holistically. After all, most of our time is consumed with our daily job and family commitments. The purpose of this article is to provide a holistic picture of investing. We will go through the various investment options available for investors to put their assets to work. We’ll get some ideas from top institutional investors who have performed well in the long run.
Myriad of Investing options
An investor has a myriad of investments to choose from these days. We may have heard about many of these investments, but we may have just invested in one or two of them. It can sometimes be confusing and sometimes daunting.
Unfortunately, investing is not taught for many in school or college and hence we don’t have any structured approach or framework for investing to follow. Let us first understand the myriad of investment options available. In the financial world, the various investment options are also called asset classes.
An asset class is a grouping of investments that exhibit similar characteristics and are subject to the same laws and regulations.
https://www.investopedia.com/terms/a/assetclasses.asp
The major asset classes are depicted below. Historically, the popular asset classes have been stocks, bonds, cash-equivalent, commodities and real estate as depicted below. This misses some of the relatively newer investing options like private equity, hedge fund, derivatives and cryptocurrencies.
If you’re interested further in evaluating the various asset classes, nerdwallet has a detailed review of major asset classes.
How do you allocate the assets?
Understanding asset classes provide a lay of the land or big picture that will help you chose the asset classes that you can invest in. Understanding various characteristics of the asset classes helps you diversify your assets (the often used “don’t put all your eggs in one basket”).
The key is to understand the characteristics of an asset class, whether you invest in it or not. For e.g. when one thinks of transportation, one intuitively understands the difference between various modes of transportation – cars, trucks, trains, buses, planes, etc, and their characteristics. Assets classes are similar when it comes to characteristics between the various asset classes.
There are various traditional asset allocation calculators available to help allocate the assets. Many of them only consider traditional assets – stocks, bonds, and cash – only. We’ll see in the upcoming section, why investors should also consider diversifying beyond these traditional assets.
Yale University’s Asset Allocation
Let us look at industry leaders when it comes to investment performance. We can look at enterprises with a good record of investment returns. Yale University is one of them. Yale University is known for its portfolio performance as it has performed better than many peers and many college endowments compare themselves to Yale’s endowment performance. Let us take a look at Yale’s portfolio below.
As we can see, Yale has allocated amongst many asset classes, some available to individual investors and some that aren’t (except for those with high net worth). Yale does invest in cash and fixed income, equities, and real estate that are available to individual investors. It also invests in private equity, venture capital, etc. that may not be available to individual investors.
California Pension Fund’s Asset Allocation
Let us look at another institution that manages many people’s money – Calpers. Calpers is California’s pension fund and manages the pension funds of its 1.9 million members. They are a leading institution when it comes to investment portfolio management. Let us take a look at Calpers portfolio below.
Essentially, Calpers has major allocation to cash equivalents (liquidity, inflation assets), fixed income, real estate and equities.
Personal Asset Allocation
Looking at Yale and Calpers has given us an idea of how a couple of leading institutions are allocating between assets. We can draw some lessons for our personal portfolio from them though some asset classes may be out of reach for many individual investors.
Thinking through risk tolerance and portfolio asset allocation is a key pillar of investing. For a majority of us, the investment universe may just consist of cash and fixed income, equities, and real estate. The exact percentage allocation for your portfolio would be based on your risk tolerance and your goals. The traditional calculators and thinking behind asset allocation is undergoing a big change.
- Traditional Assets
- Cash
- Bonds
- Stocks – Domestic and Foreign
- Alternative Assets
- Real Estate – REITs, crowdfunding, direct ownership, or private placements
- Private Equity
- Venture Capital
- Commodities
- Your Business
If you need more ideas on the % allocation, check out articles that address the various asset classes described above. We highly recommend you do this exercise on a regular basis. Here’s some advice from US SEC for investors.
If you understand your time horizon and risk tolerance – and have some investing experience – you may feel comfortable creating your own asset allocation model. “How to” books on investing often discuss general “rules of thumb,” and various online resources can help you with your decision.
For example, although the SEC cannot endorse any particular formula or methodology, the Iowa Public Employees Retirement System (www.ipers.org) offers an online asset allocation calculator. In the end, you’ll be making a very personal choice. There is no single asset allocation model that is right for every financial goal. You’ll need to use the one that is right for you.
Some financial experts believe that determining your asset allocation is the most important decision that you’ll make with respect to your investments – that it’s even more important than the individual investments you buy….
Source: US SEC’s Investor Beginner’s Guide
Investor Takeaways
Coming up with a personal asset allocation model is the biggest decision an investor can make. An investor should devote significant time and attention to this effort and get trusted financial advice as needed. After taking a risk tolerance assessment and understanding your risk profile, the next step is to understand the major asset classes and allocate them amongst your portfolio.
We’ve seen some examples of leading institutional investors and how they invest in both traditional and alternative asset classes. Leverage calculators and modern thinking around asset allocation. Write down your asset allocation model and visit it on a periodic basis. This exercise is in itself worth your time in Gold.