In order to understand why the value of your portfolio may rise or fall it is important to learn more about the characteristics of investments within each asset class. And a better understanding can lead to better decisions regarding your investment choices.
The various asset classes were suggested because they tend to complement one another. Individual investments should be chosen on the same basis. In other words, the correlation among individual investments should also be low.
Of course, it would be ideal if the best performing individual investment could be chosen year after year, but that is an unrealistic expectation that is unlikely to be fulfilled. A better course of action is to pick good solid investments that tend to complement each other as much as possible in each asset class.
The choices don’t even have to be the best ones in each asset class; they simply need to be reasonable choices made with sound logic. In some asset classes, such as gold and cash, there isn’t much opportunity for choice. In others, like equity and fixed income, the options are almost unlimited.
Given the six asset classes and the various choices within each, investors may be left a bit confused as to which individual investments fall within each asset class, the characteristics of those investments and the factors that affect their value and, ultimately, their performance.
The problem with every asset class is that the returns are not consistent from one year to the next.
While the historical long term rates of return for various asset classes can be determined, and the average rate of return is a convenient number to work with, it paints a completely inaccurate picture of what investors can expect.
When the stock market is down 30% one year, up 40% the next year and followed by a 20 % return in the third year, the average return is about 5.5% per year but it doesn’t feel like it. Nothing close to 5.5% has been achieved in any of those years, yet when an investor sees an average long term rate of return of 5.5%, that is what they expect, every year.
Since 1900 the US stock market, as measured by the Dow Jones Industrial Average, has posted negative returns in approximately one third of the calendar years. Generally speaking, any time you make an investment in the stock market you have a 33% chance of losing money over the subsequent twelve months. Returns on individual stocks are even less predictable. Despite that, the equity markets have provided positive returns – and generally speaking, the highest among all asset classes over the long term.
The same inconsistencies apply to other asset classes in varying degrees.
In order to understand why these wild swings occur, it is important to understand the factors that affect the valuations of various investments.
And understanding these factors can also help investors make decisions within their portfolios that can help improve the consistency of returns from one year to the next.
NEXT: Asset Classes - Cash
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