by Susan Lyon
So you’ve decided to invest. What you don’t know can’t hurt you, right? Wrong – so we’re glad you came here.
Before you start moving your money around, it is critical to gain a broad understanding of the different types of investments you can make and how they relate to each other. This introductory guide will walk you through the major groupings of the main types of investments, known as asset classes, which are accessible to the investing public.
What are asset classes and what are the main ones available to me?
An asset class is simply a grouping of similar types of investments. Say you invested only in these types of produce – apples, bananas, broccoli, and spinach – your general asset classes would be “fruits” and “vegetables.”
The big general asset classes are as follows, and each of these can be broken down into sub-classes by size, industry, location, etc. Here we go:
- Equities (stocks): owning a piece of a company
- Fixed Income (debt): lending money to a company or government for interest (government bonds, other types of bonds, and certificates of deposit, for example)
- Cash and cash equivalents: the money in your savings account, in your pocket, or hidden under your pillow
- Real Estate and Commodities: owning something physical like property, natural resource commodities and precious metals like gold.
From here, we can categorize each asset class in even greater detail. Just as “fruit” doesn’t tell you the exact flavor of your food, “stock” doesn’t tell you the exact flavor of your investment. Stocks can be American or foreign, startups or multinationals, value or growth, and so forth. Below are the most common ways of breaking down the Equity asset class.
Growth Versus Value
You’ve probably heard this before and thought to yourself, “Growth or value? But both sound good!” Each stock, regardless of its company’s size or geographic location, can be identified as either a growth or value stock.
- Growth: Think ‘The iPhone 5!’ It’s a stock that is expensive relative to earnings but investors think the price is justified by high potential for future growth; startups with negative earnings, but huge potential upside are growth stocks
- Value stock: Think ‘It’s on sale!’ It’s a stock that is low priced relative to earnings, dividends, or book value; there’s usually not much expectation this company’s stock price will skyrocket anytime soon, but investors are happy to hold it because there’s low downside risk and a high dividend yield (dividends paid per dollar invested)
- Blend: A mix of the two.
So which strategy is right for you? Famous investors Warren Buffett and his mentor Benjamin Graham believe in value investing while equally prestigious investor Philip Fisher was a diehard growth fan. Either strategy can work, but you need to decide if you’re looking for price appreciation (growth) or a steady income stream (value).
This is where a company is based. Hopefully that does not require further explanation.
- U.S.: companies based in the good ole U.S.A.;
- Foreign Developed: companies based elsewhere with developed economies and generally accepted currencies;
- Foreign Emerging: companies in countries with relatively undeveloped economies, generally thought to be a more volatile, riskier class, but with higher expected returns; the BRIC countries (Brazil, Russia, India, and China) are the largest emerging stock markets
Market capitalization (small-cap, mid-cap, large-cap)
Investors like to use fancy words for things, but don’t be alarmed. ‘Market capitalization’ is just a fancy way of saying “How big is this company?” Market cap is defined as the total value of a company’s tradable stock (the number of outstanding shares times the price of a share). The breakdown is:
- Large-Cap: A company whose value exceeds about five billion. Think Wal-Mart;
- Mid-Cap: A company whose market value is in the middle, usually around one to five billion;
- Small-Cap: A company whose market value is smaller, typically less than one billion
- Micro-Cap: A very small company, often less than $300 million
This is important when it comes to diversifying your portfolio, since larger companies tend to be more stable and less risky than younger, smaller ones, like startups. Then again, smaller companies can have a lot more growth potential along with that risk – that’s why it’s worthwhile to invest in a mix of cap sizes.
Here’s the takeaway: now, when you look at equity style boxes, like Morningstar’s famous style box, you can AVOID freaking out. It’s just a visual way of showing all your asset class options. This is the best-known style box for domestic equity (stock) – you’ve probably seen it before:
Which asset classes will work best for my portfolio?
Well that’s a darn good question, friend.
The truth is that there are many successful investors in both value and growth stocks, small cap and large, as well as in debt and physical assets. Unfortunately, almost none are able to outperform the “market” for very long. As an individual investor there is nothing wrong with trying to pick Apple versus Amazon as your large cap growth stock pick, but it is important that you not put your entire portfolio in large cap growth stocks or any other single asset class.
Follow these steps to set yourself up for investing success:
- First, decide on your asset class mix. Generally you should take less risk as you age because you have less time to recover from a severe loss. A great rule of thumb is to subtract your age from 110 and put that percentage in stocks and the rest in bonds. So if you are 40, put 70% in stocks (110 minus 40) and the rest in bonds (30%). If you would like to add physical assets and a little cash to the mix, maybe reduce your stock allocation to 60% and your bond allocation to 25% and add in 10% real estate and 5% cash. Be careful not to keep too much of your investment portfolio in cash since inflation will make cash worth less overtime.
- Within equities, decide how much you want to allocate to growth versus value and small versus large cap. Growth and value have performed similarly over long periods while small cap has been both higher risk and higher return than large cap. It is a good idea to have a mix in your portfolio, but as long as you don’t concentrate your portfolio in micro-cap companies you’ll probably be okay.
- Next, decide if you want to be an active or passive investor. Do you want to invest in the market “index” (own a little bit of every stock) or do you want to try to defy the odds and beat the market? If you said you’ll go with the market index that makes you a passive investor. Choose an index fund that matches your desired portfolio allocation and you’re done. If you decided to try to beat the market, you’ll have to do a little more. Proceed to the next step.
- Do you want to pick stocks yourself or pay a professional to do it? There are tons of actively managed mutual funds that will take your money and spread it across your desired asset classes (after pocketing one or two percent of your money), but the evidence suggests that most don’t outperform the market. You could try to pick stocks yourself, but be sure to pick enough (never less than twenty companies) across your chosen asset allocation so that you are well diversified. You probably won’t beat the market, but you probably also won’t do yourself too much harm.
- Research the fees involved: Whether you choose to pick your own actively managed mutual funds, or to hire a professional, there will be fees involved. These fees eat into your return, so make sure you know how much you’re paying for the advice you solicit.
- Final step: don’t touch it! If you decided to invest your money in individual stocks then you’ve probably felt the temptation to sell when they start going down or buy when a hot stock takes off. Don’t! After you’ve spent months researching an investment (and please don’t tell me you invested without putting in the time) then don’t panic every time it moves. Buying and selling too much is one of the main reasons investors underperform the market.
Confused? It may seem overwhelming, but all you really need to remember is to include a broad mix of asset classes in your portfolio.
Need help? Lots of companies offer “target date” funds that do the asset allocation for you. These funds manage stock/bond mix for you, depending on the date you say you are going to retire. Say you plan to retire in 2045: When you are younger, it will offer a more aggressive stock-heavy portfolio, but the fund will automatically reallocate to become less risky as the year 2045 approaches and your investment time horizon shrinks. While these types of “target” funds are often used for targeting retirement, you can also use them for shorter-term goals like a child’s education. It’s not all on auto-pilot however, 2 funds with the same target date can have vastly different stock/bond mixes. It’s important to do your homework and make sure that the mix is in-line with your risk tolerance.