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This article is intended for the educated layman. It was written as part of a continuing series of articles on a variety of investment topics. To view all the articles in this series, click on “More by the same author” in the left margin.
I coulda had class. I coulda been a contender. I coulda been somebody, instead of a bum.
Part 1: Assembling the Pieces
Why asset class allocation?
Imagine that you want to prepare a meal, and that you know very little about cooking. You go to a foodie friend who has culinary expertise, and he advises you, “The most important thing is good food.” You ask for something a little more helpful, and he tells you that good food begins with fresh ingredients. You press for some practical guidance, and he tells you how you can identify, for each kind of ingredient, what is fresh and of high quality. And finally, seemingly pulling all this advice together into something truly useful, he provides a brief conspectus of the art of combining and cooking the ingredients into dishes.
This may be all well and good if you want just to cook something, anything, regardless of what it is. But unless you already know that one or more of those dishes is right for you, this advice is almost certainly insufficient. It lacks something important, even apart from step-by-step instructions: Organizing principles. Are you interested in appetizers, main courses, desserts, or even a complete five-course meal? Is this a summer meal or a winter meal? Do you or your guests have allergies that have to be taken into account?
At this point in our discussion of investing, you’re in a similar fix. We’ve looked into the ingredients of investing, and, in my last essay, we saw how to cook these ingredients together to make a portfolio. That may at first have seemed sufficient: Gather together good investments (or at any rate, investments), and then optimize them. As I explained, to optimize the investments means, mix them together into a portfolio in proportions that maximize their combined return at a level of investment risk such that the balance of return and risk is exquisitely suited to your taste. But even knowing how to optimize, you still lack organizing principles for sorting through all the possible ingredients and recipes that you might cook into a portfolio.
Abandoning the culinary metaphor, from which I’ve sucked out pretty much all nourishing meaning, I will consider in this essay one dominant method for making sense of the investments that we put into our portfolios. Making sense – but not yet developing an overall plan. That will come in my next essay but one.
Almost from the first of my essays, I’ve oscillated between references to discrete investments, like individual stocks and bonds, and references to entire classes of investments, like stocks as a collective, and bonds as a collective. While I did this with the worthy intention of making my expositions clearer, it was wooly intellectually.
The organizational method that I’m considering here sorts this out. It is asset class allocation, or just asset allocation for short 1: building a portfolio not so much from a consideration of individual, discrete investments as from the larger, more or less homogeneous agglomerations, like “stocks,” “bonds,” “real estate,” “venture capital,” and so forth, to which the individual investments belong.
There are other organizational methods. One, which I will introduce in my next essay, is more esoteric and works best with stocks alone, though it can be applied to other kinds of investments. It consists of what we in the profession call alpha and beta. Beyond this, the classification of investments according to their status under tax laws ranks very high, but I will pass over that because it depends so mightily on politics and ever-changing tax law, possibly rendering whatever I might say irrelevant after a year or two.
Asset class allocation has been so thoroughly absorbed into the culture of investing that today, most investment guidance is built around it, and you may even have heard that it is the foundation of an investment plan. And like nearly all respectable investment ideas, it is misunderstood and abused. One misconception is that asset class allocation and portfolio management are the same thing. Toward the end of this essay (in Part 2), I’ll explain why they aren’t. Let’s start by considering another misconception.
What is an asset class?
Once, in a newspaper advertisement placed by a Wall Street firm, I saw the firm’s wise investment counsel depicted in a schematic like this:
What’s wrong with this picture?
Stocks, bonds, and real estate are asset classes, groups of discrete investments that share fundamental economic and legal features with other members of their class, but not with members of other asset classes. For example, a bond represents a loan by the holder of the bond (the investor) to its issuer (normally a government or a corporation), and the issuer must, with rare exceptions, repay this loan by a specified date, usually with interest. A stock, in contrast, represents, not a loan, but a share of ownership in a corporation, with no terminal date. Real estate is also a matter of ownership, but of land and whatever buildings are on it. Mutual funds, in contradistinction to all of these, are only vessels, containers for stocks and bonds and so forth; they are not an asset class. When you collect exotic fish, you don’t count the glass tanks as a separate species, not even if the glass is molded to look like a fish. Similarly, exchange-traded funds (ETFs), which you can buy and sell as if they were stocks, are not stocks, but vessels that contain multiple individual investments. Management companies can gather up stocks, bonds, and even real estate (in the form of real estate investment trusts, or REITs) into mutual funds and ETFs. Although mutual funds and exchange-traded funds are not in themselves asset classes, you can characterize them as belonging to the asset classes of the investments that they contain. Some mutual funds and ETFs are stock funds; some are bond funds; and some are combinations. A technology stock mutual fund, for example, can be classified as “stocks.” Exchange-traded funds are still comparatively new – twenty years old this year – but there’s a kind of mutual fund, the closed-end fund, that is somewhat similar to them in that you can buy and sell shares of a closed end fund on the stock exchange as if they were stocks, and such funds have been around for a very long time.
1. I’m the only person I know who rigorously insists on using all three words, “asset class allocation.” I do so because the full expression’s meaning is clearer. On rare occasions, I’ve heard “asset allocation” used to mean the choice of weights to place on individual assets, not on classes of assets. You’re far more likely, though, to hear “asset allocation” in the sense of “asset class allocation.” By the way, the term for allocating investments among different accounts according to their tax status is “asset location,” but this is much less commonly used.