Investment Asset Classes and Their Role in Portfolio Diversification
Updated: Mar 3, 2020
A couple of weeks ago, we offered some guidance on how to approach defining and planning for your financial goals as well as the types of investments that may be suitable for them. This week we are going to take a closer look at exactly what comprises a diversified portfolio and the risks involved with each portfolio component to better help you gauge just how much risk you can potentially handle.
Before addressing portfolio diversification or asset allocation, it’s important to understand the various asset classes that might be included in your portfolio. Let’s take a moment to define the different assets and understand their pros and cons:
Large Company U.S. Stocks
This category of stocks refers to companies that have a market capitalization (the number of company shares outstanding multiplied by the price of the shares) of more than $10 billion. Sometimes referred to as blue chip companies, examples of Large Cap stocks include companies like Apple, Microsoft, and Johnson & Johnson. Typically, Large Cap stocks represent the core or largest percentage of a stock portfolio. Because they are the largest and most well-established of U.S. companies, they also tend to be stable and recognizable and given their size, they are very often transparent, with public information being very accessible. While there is both growth opportunity, as well as potential for downside risk, the degree to which you will see these attributes can be considerably less than investments in other equity asset classes.
Small Company U.S. Stocks
Small Company U.S. Stocks refer to companies with a market capitalization of between $250 million to $2 billion. Examples of Small Cap stocks include Redfin, Alaska Airlines, and Teradyne Inc. Because of the relatively small total value associated with them, as well as the fact they may be earlier in their business cycle than Large Cap companies, Small Cap stocks may experience larger earnings growth and as a result higher stock value appreciation potential. However, they may also can tend to be more volatile, and for that reason should be a smaller portion of your asset allocation.
International stocks are typically classified as either Developed or Emerging market stocks. Developed Market stocks are the most advanced in terms of their markets and economies, and include countries such as the United Kingdom, Germany, Australia, and Japan. These countries must not only be high income, but also include openness to foreign investors and efficiency of capital markets. Emerging Markets are countries that are currently in a high growth phase with rapidly expanding and sometimes transitioning market and economic environments. Examples of Emerging Market countries include China, India, and Brazil. International stocks provide an opportunity for investors to diversify outside of their home country and gaining exposure to different types of investments can be a great way to potentially enhance returns and reduce portfolio risk. However, international assets expose investors to a unique set of risks such as exchange rate, foreign interest rate, and geo-political risks. And because of the greater amount of uncertainty present in Emerging Markets, they tend to have higher risks and greater return potential than Developed Markets equities.
Fixed Income (Bonds)
Bonds are considered to be the part of an investment portfolio that offer stability, a fixed, predictable stream of investment income and if an investor is using individual bonds, capital preservation. Government and Corporate bonds are the most common types of fixed income. The importance of the role of bonds in terms of asset allocation is they can add stability and downside protection when the equities markets are performing poorly, reducing portfolio volatility during these periods.
Each of these asset classes plays a different role when it comes to your portfolio and can protect and benefit you in different ways and at different times. Be sure to check back tomorrow as we investigate different risk profiles and the importance of diversifying your portfolio for long-term financial success.
Contact the Peninsula Wealth Team for a free consultation to begin building a financial and investment plan customized to your goals.