Designing Your Portfolio Pt 3 — Choosing Asset Classes

This post, which was originally written on The White Coat Investor is a part of a series that introduces you to both asset allocation and location. Enjoy!

Designing Your Portfolio Pt 3 — Choosing Asset Classes

This is the third part of the Designing Your Portfolio series.  Part 1 discussed goal-setting, and part 2 was about the relationship between your savings rate and your necessary portfolio return.  When designing a multi-asset class portfolio, one of the hardest steps is to decide which asset classes you should include.

The Ideal Asset Class

An ideal asset class has three important characteristics.

1. It has a long-term positive expected return, preferably much higher than the expected inflation rate.
2. It has a low correlation, preferably even a negative correlation with all your other asset classes.
3. It has enough securities within the class to minimize individual security risk.

If an “asset class” only contains 10 stocks, that’s not a very good asset class.

How Many Asset Classes Do You Need?

My opinion is that you need at least three asset classes in your portfolio.  Seven is a pretty good compromise between the benefits of simplicity and the possible better performance of a complex portfolio.  Once you have more than ten, you’re just fooling yourself that you’re doing any good and you’re really just tinkering for the sake of tinkering.  The law of diminishing returns really starts kicking in as you move past 3-7 asset classes.

I can think up a couple of dozen relatively common asset classes.  It’s easy to see you don’t need to include ALL of them in order to get the benefits of a truly diversified portfolio.  Also, some broad-based funds can give you access to several asset classes at once.

In fact, Mike Piper who blogs at The Oblivious Investorchanged his entire portfolio to just a single multi-asset class mutual fund.  Simple, yet sophisticated.

How Much Complexity Do You Desire?

The more asset classes you add, the more complex your portfolio becomes.  That does several things:

1. A more complex portfolio might give you the opportunity for increased returns, especially if a lot of the asset classes are high-risk/high-return classes.
2. It is guaranteed to increase your investment costs and the time required to manage the portfolio.

You might not mind complexity, but you also need to consider your spouse and/or heirs.  It’s not uncommon for heirs to discover the portfolio of their recently deceased beloved contains 200 individual stocks and another 50 mutual funds.  Guess what they’re going to do when you die with a portfolio like that?  They’re going to run to the nearest Edward Jones store and hire them to do it for them.

You also need to keep in mind that if your portfolio is split among 5 or more different types of accounts, then having 15 different asset classes is going to make keeping track of it all immensely complex.  But if all your investments are in one Roth IRA then perhaps that isn’t such an issue.

Tax Considerations

As William Bernstein related in his excellent discussion of Taxable Ted and Sheltered Sam, if your investments are primarily in a taxable account, you probably want fewer, more broad-based asset classes rather than many, narrow asset classes in the portfolio.  This not only improves the tax-efficiency of the individual investments, but also simplifies rebalancing down the road.

Unique Opportunities

You may also have the opportunity to include asset classes that other people don’t and should take these into consideration when designing your portfolio.  This may be a function of what is in your 401K, or may be related to your individual business.

For example, when I was in the military I had access to the government 401K, the TSP.  This very-low-cost plan contains a foreign developed market index fund (I Fund) offered at very low cost, as well as an extended market fund (S Fund) that is much cheaper than can be bought anywhere else, including Vanguard.  It made sense to use these building blocks in designing my portfolio given how attractive the opportunity was.  In addition, the TSP offers an asset class not offered anywhere else, the G fund.  This is a money market fund on steroids, offering the yields of a 10-year treasury with the risk of a 3-month treasury bill.

Others may have access to the TIAA-CREF real estate fund, which functions quite differently from a REIT fund.  You might also have the opportunity to buy syndicated shares of a surgery center, urgent care, or even your hospital.  This unique asset class might only be available to you, and that should be considered when building your multi-asset class portfolio.

Part 4 in this series will briefly discuss many of the asset classes you may wish to include in your portfolio, including their pluses and minuses.