Asset Classes - The building blocks

Before we delve into the topic of Portfolio Management lets talk a bit about asset classes. They form the building blocks of a Portfolio. Examples of asset classes are equities, bonds, real estate (direct & indirect), commodities, precious metals (gold), private equity & venture capital. For an average (but sensible!) investor only three asset classes matter: equities, bonds & real estate (primarily indirect & direct only to the extent of personal home). I will state the reasons for this while discussing the characteristics of each of these asset classes in the next few posts.

Determining the right mix of asset classes in ones portfolio is called Asset Allocation. It is a very important part of Portfolio Management. If one were to define the essence of Portfolio Management then it would be all about Asset Allocation. According to some widely accepted academic research, sources of investment returns can be decomposed into 3 things:

• Asset Allocation: the mix of asset classes in a portfolio (e.g. 60% Stocks, 20% Real Estate & 20% Bonds or 20% US Stocks, 20% International Developed Stocks, 20% Emerging Market Stocks, 20% US REIT & 20% US Treasury Bonds)
• Market Timing: jumping into & out of an asset class with the anticipation of rise/fall in its value (e.g. trying to time the stock market)
• Securities Selection: cherry picking only a few securities within an asset class based on their attractiveness (e.g. picking winners like Infosys instead of going with large cap Indian IT stocks as a whole)

As per a famous empirical study by Gary Brinson (one of the most influential investment managers in the institutional investing landscape) & others, over 90% of the variance in returns between two portfolios can be explained by the difference in their asset allocation (e.g. if fund A generated higher returns than fund B, over 90% of that higher return can be attributed to fund A's investment in better performing asset classes). For a more detailed discussion on the importance of asset allocation please refer to two of my favorite books 'Unconventional Success' & 'The Intelligent Asset Allocator'. If you are on a time crunch, here is an hour long lecture by David Swensen on the topic.