1. Classifying asset classes

Classifying asset classes

The goal of an investor must be to build a balanced portfolio of investments with relatively stable overall rates of return

By: | Published: February 23, 2016 12:06 AM

The saying ‘do not put all your eggs in one basket’ has been around for ages. But, with the advancement in investment science literature during the last couple of decades,  creation of an optimum investment portfolio is not simply a matter of combining a lot of unique individual securities that have desirable risk-return characteristics. Specifically, modern portfolio theory shows that you must consider the relationship among the different asset class in your portfolio which will meet your investment objectives. If that is the case, what is the optimal portfolio and how many asset classes one should have in his portfolio.

Variety of asset classes

Being an investor in the 21st century, you have an array of investment choices unavailable a few decades ago. Together, the dynamism of financial markets, technological advances, and new regulations have resulted in numerous new investment instruments and expanded trading and investment opportunities. Improvements in communications and relaxation of international regulations have made it easier for investors to trade in both domestic as well as global markets. Nowadays, a typical portfolio consists of not only shares and bonds but also a variety of asset classes such as complex derivative instruments built upon shares and bonds, commodities, bullion, real estate, raw land, land development, rental property, antiques, art, coin and stamps, vintage textiles. So, the asset classes ranges from real assets to financial assets and most liquid to least liquid assets.

Advantages of diversification

As an investor, you need to understand the differences among investments so you can build a properly diversified portfolio that conforms to your objectives. That is, you should seek to acquire a group of investments with different patterns of returns over time. If chosen carefully, such portfolios minimize risk for a given level of return because low or negative rates of return on some investments during a period of time are offset by above-average returns on others. The goal is to build a balanced portfolio of investments with relatively stable overall rates of return. As an investor you should understand and evaluate the risk-return characteristics of investment portfolios. While making appropriate diversification, you should avoid the following common mistakes.

Avoid too many asset classes:Always keep your holdings down to a manageable number of asset classes. It could be as few as 20 and not more than 30 in reasonable amounts invested in each asset classes. Avoid going for outsized bets. Yes, the holdings should be diverse in the sense that the value of these assets should not be tightly coupled with one another. Buying shares in 20 fast moving consumer goods companies will not diversify your portfolio whereas buying shares in 20 different sectors and industries is actual diversification. By the way, having fewer investments means having an easier time making sense of it all.

Commodities are meant for trading:

Investment in commodities are to be traded, not owned. You would never have heard of a successful commodity investor, but you might have met many commodity traders who are just as comfortable in selling bear markets as buying bull markets. They spot opportunities and do not feel compelled to be in all commodities all the time. Buying and holding these type of asset classes will not build your wealth over the long term whereas you need to behave like a trader.

Market cap matters: Generally, small cap shares and large cap shares rise and fall together. So, it is not a good idea to buy the shares based on market capitalization. It is always better to find strong businesses and invest in those regardless of what the total market cap is and to which category the company belongs to.

Keep little invested in illiquid assets: The illiquid assets could be range from antiques, art, coin and stamps, vintage textiles, wines, cars, etc. Often these assets were probably worth more than what you have paid for them. But, in reality, you could probably find difficulties in identifying buyers for the same to realise the profit.

When you have too many asset classes ranging from shares to collectible in your portfolio, it becomes nearly impossible to get a good knowledge and grasp on each holding. When you lose your focus obviously you lose your competitive advantage as an investor. Instead of having a competitive insight, you begin to run the risk of missing things. Having an assumption that more asset classes are safer you run into over-diversification.

To conclude, there is no definite and conclusive answer for how many different types of assets you should own in your portfolio. But whatever number you are comfortable and settle on, the real goal is to arrive at a reasonable balance which means enough variety to provide adequate diversification but without going overboard.

The writer is associate professor of finance & accounting in IIM, Shillong

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