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Don’t skip leg day, properly diversify your portfolio: Asset allocation (Concept 2)

skip leg dayExercise and accumulating wealth. The two have more in common than you’d think. When I was young my exercise routine used to focus almost exclusively on bench presses and bicep curls. Why? For all the wrong reasons of course — the action stars of the day had big arms and you were considered “strong” if you could bench press a lot. Predictably my arms and chest grew far faster than the rest of my physique, which made me happy — until friends started to tell me it was time to balance things out.

Investors sometimes do the same with their portfolios, investing heavily in a few groups while completely ignoring others. Had I been wiser, I would have started with my diet. Good eating habits often have a much bigger impact (up to 70 – 80%) on weight loss than exercise.

Growing your portfolio isn’t that much different from a well-balanced exercise routine. In my last post, I discussed the importance of diversifying your portfolio. Now we can look beyond just having a variety of industries. Let’s think in terms of asset classes, which brings us to the second concept for financial success:asset allocation.

An asset class is a group of investments or securities whose risk factors and expected returns are similar to each other. Each separate asset class usually provides diversification from one another. Up to 90% of the variance in a portfolio’s return is determined by its asset allocation.

For example, in the 2008/09 market crash, most portfolios consisting solely of equities or stocks were down in the neighborhood of 45 – 55%. On the other hand, a portfolio of all high quality fixed income assets actually had positive returns.

Although it’s possible to break asset classes down into sub-categories, let’s look at the five major classes that you can invest in.

Asset AllocationFixed Income: The old faithful
Fixed income assets are by far the least volatile and you can typically expect an annual return or interest rate. In the event of corporate bankruptcy, bondholders are paid out in full before the owners of the company receive a dime.

U.S. Stocks: The American Dream
The U.S stock market is universally recognized as the largest and most liquid stock market in the world. Today, U.S. companies generate less than half of their revenues and profits from within their own borders — quite different from many years ago. The country’s stock markets are now considerably more correlated with other markets around the world.

REITs: Acquire land
In spite of recent dramatic corrections in global real estate markets, the long-term risk/return performance of Real Estate Investment Trusts has been significantly better over the last four decades than other classes.

REITs are companies that own and manage real estate — usually commercial properties. They consistently pay out a strong dividend, which has sheltered investors somewhat from declining overall returns. REITs also provide considerable diversification benefits when used with other asset classes.

International Stocks: Go global
These are stocks outside the U.S. markets and include a diverse range such as Europe, Asia, South America, the emerging markets, and Canada. Globalization has considerably blurred the line between international and U.S. securities. Due to this, the benefits of diversifying between these two asset classes have diminished considerably.

Commodities: Materialize
Commodities have the dubious distinction of having the highest risk amongst the five classes and have had the poorest investment returns over the past four decades. They cover the energy, precious metals, base metals, and agriculture sectors. But, when used appropriately and systemically, commodities can play an important role in improving the risk/return profile of a diversified portfolio.

And there you have it, the five major asset classes. In my next post, I’ll discuss Concept Three: Designing Efficient Portfolios.