Which Assets in Your Allocation?
You have completed your investor profile. That drives your target asset allocation.
Now you must determine acceptable investment options.
What asset classes and sub-classes to include in, or exclude from, your investment universe.
Core Asset Classes
There are three core asset classes: cash, fixed income, equity.
Previously, we have considered each in some detail.
For a review of cash, please read Cash & Cash Equivalents and Money Market Instruments.
For fixed income, please read Bonds, Notes, and Debentures and Preferred Shares.
For equities, Common Share Characteristics may be useful.
Core Asset Subclasses
Within each of the core asset classes, there are a variety of subclasses.
It is important to understand and differentiate between the subclasses. The core classes may have general risk-return characteristics. But within the class itself, these characteristics can change significantly.
For example, shares in Coca-Cola and shares in a small Kazakstan mining company are both equities. But each has extremely different risk-return profiles. Or Venezuelan bonds are much higher risk than US debt of similar term to maturity.
In future, we will look at differing risk within a specific class.
Within the core classes, you should consider:
Countries
Are there countries or regions that you wish to focus on or to completely exclude?
Perhaps you grew up and worked in Brazil. You might have a better understanding of investments in that country and that may give you a competitive advantage.
Perhaps you live in a country which has investment restrictions on another country. For example, many countries currently have sanctions against dealing with Iran and North Korea. Even if you wanted to invest in these places, it might be difficult to do so legally.
Perhaps there are countries that you do not want to invest within due to personal beliefs. During Apartheid, many countries and individual investors excluded South Africa from their investment portfolios and trading.
Industries
The points I made with countries are also applicable to industries.
Perhaps you are a geologist in Western Canada’s natural resource industry. That may give you special insights into investments in the relevant sectors. As opposed to the software engineer in Silicon Valley.
Many individuals believe smoking is evil and refuse to invest in tobacco industry companies. Pacifists may want to exclude companies that operate in the military areas. And so on.
As well, today there are many socially responsible investors. They actively seek out environmentally friendly and/or socially conscious companies in which to invest their capital.
There are many investment funds that cater to socially responsible and green investors.
Nonsystematic Risk Levels
Within an asset class, individual investments may have relatively higher or lower risk than the class itself.
Do you want to include or exclude higher risk investments?
If so, what is your threshold?
Consider fixed income long-term bonds. Most investors only consider investment grade debt. But if you have a lower or higher risk appetite than most investors, you might want to further limit or expand your debt investment options.
Investment Styles
We have looked at a few different investment styles already.
The main one is growth versus value. Very similar is capital gains versus dividend income. Another common style question involves market capitalization – large versus small.
Or domestic versus global. And when investing internationally, do you hedge currencies or not?
You may invest based on ratios, such as price-earnings or price-book. Perhaps you prefer funds over shares. Active management versus passive. To list a few. There are many choices and sub-choices.
Are there styles you like and wish to utilize?
What about styles that make no sense to you?
Perhaps you believe value investing is right for you and that growth strategies are too risky.
Or perhaps you want to focus on nano-cap stocks and have no interest in the mega-cap sector.
You may also see different styles or approaches taken together to arrive at chosen investments. In large part, this is what takes place in Factor Investing. Currently trendy, well-marketed, investment products. Given the hype, we will likely review Factor Investing in the future.
Your investment philosophy, knowledge, and risk tolerance may lead you to include and exclude certain styles.
Taxes
Investment returns are typically taxed in different ways. In many countries, there is one effective tax rate for interest, another for dividends, and a third for capital gains.
Depending on your income and tax situation, you may want to concentrate on one type of investment and ignore another.
If you live in a jurisdiction that allows tax-free or tax-deferred investment accounts, that too should impact your investment strategies and tactics. For example, in Canada, eligible dividends are taxed at lower rates than interest income or capital gains. It may make sense to hold dividend producers outside tax-deferred accounts. Then hold higher taxed investments within a tax-deferred account for better overall portfolio efficiency.
Alternative Asset Classes
Traditionally, investors focus on the three core asset classes.
But obviously there are other asset classes that merit investment consideration. Once we have covered the core classes, we will review non-core investment options.
Inclusion or exclusion in one’s portfolio of alternative asset classes will depend on three key variables: the investor’s unique profile, especially risk tolerance; understanding of the product and its place in the portfolio; comfort and ability to properly trade these alternative assets.
That said, you will often end up with alternative asset classes in your portfolio just by investing in the core asset classes.
For example, a diverse Canadian equity portfolio will include natural resource and other commodity related companies. Real estate is another asset class that will be in a diversified portfolio.
Hopefully that provides some guidance in assessing assets to include in and exclude from your portfolio.