Historically, the one-fund portfolio has performed well, with the occasional 30% to 50% drop. Don’t like the sound of that last part? You may want to consider adding an asseet class.
The classic three fund portfolio gives you three asset classes, and a four fund portfolio (with the addition of Real Estate usually in the form of REITs) gives you four.
I’ve got those four. I’m further diversified within real estate by owning not only Vanguard’s REIT index fund, but also have equity and debt investments via crowdfunding platforms.
I’ve also invested in a website and a couple of microbreweries. How should one go about adding asset classes? I’ll let the Dr. Jim Dahle address that. The remainder of this post was written by him and originally published on The White Coat Investor.
7 Guidelines for Adding New Asset Classes to Your Portfolio
The benefits of having several different asset classes in your portfolio are well-known. There are dozens of increasingly exotic asset classes available to invest in, including frontier market stocks, U.S. small growth stocks, Japanese real estate, and British inflation-indexed bonds. An investor need not invest in all of them in order to be successful in reaching his financial goals.
The point of holding multiple asset classes is to boost returns and decrease risk through diversification. Since neither you, nor I, can predict the future, you want a portfolio that is going to do acceptably well no matter what happens in the world.
Consider these guidelines when deciding whether or not to add a new asset class to your portfolio.
#1 Number of Asset Classes
If your portfolio currently contains only one or two asset classes, you will almost surely benefit from adding another one.
Although the benefit of adding an additional asset class to the portfolio goes down with each new asset class, the benefits can be dramatic initially. As you add more classes, you are weighing the additional diversification against the added complexity and expenses inherent in a more complicated portfolio.
An investor with a tiny portfolio relative to what he will eventually need to retire can start out with a single asset class, since the effect of additional savings will dwarf the effect of the investment returns of the portfolio. As the portfolio grows, he will want to consider additional asset classes to provide diversification.
As a general rule for a portfolio of reasonable size, I would consider a bare minimum of three different asset classes. Seven asset classes provide a great balance between diversification and complexity. There is very little benefit to additional asset classes once you get to 10. Rather than adding an additional class to an already complex portfolio, perhaps you should consider replacing one that you currently have instead.
#2 Avoid Performance Chasing
The addition of new asset classes to a portfolio is often used as an excuse by the investor to engage in the harmful practice of performance chasing. Investors consciously and subconsciously project the recent past into the future, despite the well-known fact that past performance is no indication of future returns.
As such, it was popular to add small value stocks and REITs to portfolios in 2003-2007 and to add gold and long-term treasuries to portfolios in 2010-2012.
These days, after years of outstanding stock performance, investors are talking about a “100% equity” portfolio again. While adding any of these asset classes to your portfolio may make sense for the long run, be sure to carefully examine your motivation to ensure you’re not just chasing performance.
If you’re convinced an asset class belongs in your portfolio, consider adding it after a period of poor performance, rather than when it is the “hot” asset class.
#3 Low Correlation
When adding an asset class you want to make sure it is fundamentally different from what you already own.
Bonds are loans to companies or governments. When you own a stock, you own part of a company and share in its profits. REITs invest primarily in real estate and have a different tax structure than a more typical stock.
On the other hand, if you have a portfolio consisting of large growth stocks and small value stocks, adding some large value stocks (which have relatively high correlation with the other asset classes you hold) probably isn’t going to get you the bang for the buck you would get from adding some bonds or real estate (which have a much lower correlation with the stocks you already hold).
Historical correlations are relatively easy to look up. Correlations vary over time, but you’re looking for an asset class that is non-correlated with your current asset classes as much as possible.
#4 Positive Real Returns
Just about anything and everything — including stocks, bonds, crowdfunded real estate, precious metals, art, timber, whole life insurance, and horse manure — can be considered an asset class.
Low correlation with the rest of your portfolio is important; however, it is also important to have asset classes that are expected to provide a positive, after-inflation return. You’re investing, not just collecting.
If too much of your portfolio is in asset classes with a low expected return, your entire portfolio may not have a return sufficient to meet your goals. Gold is a classic example. If you had an ounce of gold 500 years ago, you could use it to buy a man’s suit. Today that ounce of gold still just buys a man’s suit.
Given our current historically low interest rates, many fixed income asset classes currently don’t have expected returns much higher than inflation. While there is some argument for holding an asset class or two without an expected positive real return in your portfolio simply for the overall diversification effect on the portfolio, you certainly want the vast majority of the portfolio to beat inflation.
For many years, an investor was only able to invest in a few asset classes because others simply weren’t accessible in a way that allowed an investor to be diversified within the asset class at a reasonable cost.
In recent years, dozens of previously inaccessible asset classes have become accessible thanks to the explosion of the index fund and ETF markets, providing investors many new options.
When adding an asset class to a portfolio, an investor ought to consider her liquidity needs. While a typical investor doesn’t need instantaneous liquidity for his entire portfolio, it is important to be able to have a reasonable amount of liquidity in the portfolio for unforeseen personal needs, investment opportunities, and portfolio rebalancing.
If most of your portfolio is tied up in individual real estate holdings, hedge funds, and other private investments, you should lean toward an asset class that can be liquidated any time the markets are open, such as publicly traded stocks and bonds.
#7 Tax Implications
An investor who has very little tax-protected “space” in his portfolio (such as IRAs and 401(k)s may find that the diversification benefits of a particularly tax-inefficient asset class such as REITs or TIPS may not be worth the additional tax cost. He may instead prefer to invest in tax-efficient stocks, municipal bonds, and individual rental properties.
Likewise, an investor whose portfolio is primarily tax-protected can consider high turnover stock asset classes (like microcaps) and particularly tax-inefficient asset classes such as Peer to Peer Loans.
Even within a taxable account, investors with high taxable income are much more likely to benefit from adding an asset class such as municipal bonds than an investor with a lower income.
While a wise investor rarely changes his investment plan, there may come a time when the inclusion of a newly-investable asset class in the portfolio is prudent. Use these guidelines to help you decide whether the benefits of adding an asset class outweigh the downsides.
What other factors help you decide whether or not to add a new asset class to your portfolio? Comment below!
11 thoughts on “7 Guidelines for Adding New Asset Classes to Your Portfolio”
I always recommend diversification to avoid risk and investing in multiple classes. However, I do mention that as you should continually buy investments but when the markets change you should buy more of one type of class.
Nice article! I have recently been thinking of investing in crowdfunded real estate. I currently have a couple stock market portfolios. One is a moderately aggressive dividend growth portfolio that I trade options in. My other portfolio is made up of several index funds. So far, my returns have been pretty great; however, I do not want all of my assets to be comprised of stocks. Anyway, nice article. You gave me quite a bit to think about.
Owning a dab of gold (gld or miners) is like owning some insurance. It’s purpose is not to “make return” it’s purpose is to protect the property in a downturn. When you buy stock you buy property, which you expect to later sell at an appreciated value in an up market. If the market crashes you don’t want to sell those stocks and in fact you would prefer to buy more stocks. Gold in a crash tends to soar, so it’s the perfect “thing” to “sell high” and convert either into hamburgers or more stock when it hits the fan. The rule is buy low sell high, not buy low sell lower. If gold protects you from selling stocks lower, it’s worth it’s weight and provides the asset diversity you desire. The problem in the above article’s logic is it’s accumulation phase logic. You eat your W2 money and never sell anything while accumulating. It’s a different risk story when the portfolio starts feeding you instead of the W2. This is how administration of non-correlated diversity actually works. It gives you assets to sell that are non correlated so you can sell what is “high” at any given time relatively speaking. Owning global vs small cap vs large cap vs REITS provides virtually no portfolio protection because they are all “stocks” all tend to normalize to a correlation of 1.0 in a downturn. In a market crash all equity arrows strongly point into the dirt.
Ecclesiastes 11:2 Invest in seven ventures, yes, in eight; you do not know what disaster may come upon the land.
Diversified investments is a very old concept. This one is a several thousand year old piece of advice from King Solomon. Seems like a good idea.
Dr. Cory S. Fawcett
Prescription for Financial Success
lol thank you for that article! As I was reading it though, I couldn’t help but wonder have you guys heard of Wealthfront? It’s the millennial roboinvesting version of what you mentioned. They diversify your money across various ETFs of stocks, frontier stocks, metals, natural resources, bonds. And they do tax loss harvesting as well when one ETF isn’t doing well, they sell that and invest it in a similar ETF. My risk tolerance setting is a 9/10 and they diversify my money for example, and spread my money across 3 different corporate bond mutual funds alone. Not to mention the 3 for American stocks, 3 for development world stocks, I think 2 or 3 for metals, and 1-2 or natural resources, some bonds, etc. Fees are 0.25%. But I can only assume what you mentioned is cheaper in the long run because you buy and hold without selling any classes in your portfolio?
Definitely heard of it, and at some point when I have the time, I’ll probably take a closer look and compare it with similar services like Betterment.
I’m not sold on the idea of crowd-funding in general. I don’t like the lack of control. There are real benefits to real estate, if YOU own the real estate. This crowd-funding stuff only promises you a return on investment. You don’t get, for example, the direct, yearly depreciation benefit. And usually even the estimated ROI isn’t high enough to negate the risk of just leaving it in VTSAX/VTI. I understand I don’t have control over the stock market either, but it has decades of returns that’s I’m pretty comfortable with the risk. I do like the concept of hard-money lending (lending money at a high interest, where the asset backs the value of your loan, and you get first money out) — it’s “can’t lose!” in general. But when you give the decision making over to a team of people you have no control over, that rarely goes well.
How much do you expect to increase your annual returns by holding different asset classes over just owning vtsax? Dr Dahle says that the increased diversification will boost returns which i understand in theory but theres no real concrete numbers to back this up?
It’s based on “modern portfolio theory.” The idea is to get the optimal returns for a given level of risk.
3-5 non-correlated asset classes are fine.
I was very diversified going into 2007-2008. Or so I thought. I had over a dozen “asset classes.” Or so I thought. Everything went down. Including small growth, large value, international, emerging markets, preferred stock, high-yield bonds, etc.
The only exception was short-duration high-quality bonds.
If you don’t like 40-50% drops consider investing less in any kind of equity, even REITs.
I’m not saying real estate can’t be part of that. The rents, long-term appreciation, and tax advantages are great.
But don’t forget fixed-income investments if you don’t want even a short-term drop in value.
When I first started investing, I was too diversified. I had too many different mutual funds with too little money. Now with a lot more money I have fewer funds. It doesn’t take very many choices to be well diversified. But it does take more than one.
Dr. Cory S. Fawcett
Prescription for Financial Success