Engage in Asset Class Warfare and Win

Physician's Money Digest, July31 2003, Volume 10, Issue 14

There's a major class warfare going on outthere. But it's not the one you keep hearingabout. It's the asset class warfare. But don'ttell that to the investment management community.They've been pouring a lot of money into advertisingto get you involved in the battles.

You're probably asking, what's thiswar about, and should you get involved?You should get involved, butonly on your terms.

ALLOCATE YOUR ASSETS

An asset is a fancy name for anythingyou invest in. Stocks, bonds, real estate,artwork, etc, are all assets. An asset classis a group of assets bearing commoncharacteristics. There's no governmentagency out there responsible for definingasset classes. You can pick any commoncharacteristics and define an asset classon that basis. So why should you, as aphysician-investor, care about asset classesat all, and how should you go aboutdefining asset classes?

By now you've learned that asset allocationis probably the most importantfactor in long-term investment results. Asset allocationis spreading out your investments over severaldifferent asset classes. The whole objective of assetallocation is to match the risk-return profile of yourportfolio to your risk tolerance and other requirements.This is based on one of the most importantdiscoveries of modern financial theory, which showsthat by combining dissimilar assets, you can gethigher expected returns for the same risk, or thesame expected return for lower risk.

This almost sounds like a free lunch. It is—inthe sense that if you're not smart enough to takeadvantage of it, you'll be penalized for your ignorance.If you don't allocate assets, you'll end uptaking more risk than necessary to getthe same expected return. But to earnthis free lunch, you have to combineassets or asset classes that are dissimilar.You can probably deduce that ifyou buy stocks of General Motors,Chrysler, and Ford, you won't getmuch diversification or lower risk.

DEFINE ASSET CLASSES

So you have to define asset classesthat have different risk-return characteristics.We can say that for sure aboutstocks and bonds. They have very differentcharacteristics. So we can defineeach as an asset class. We can also say thesame about short- and long-term bonds,because they respond to interest ratechanges differently and have differentreinvestment and default risks.

How about growth stocks and value stocks?Do they have different characteristics? Are theydifferent asset classes? They are, but there are nounique, universally accepted definitions forgrowth and value stocks.

Their interest:

How about giant, large, medium, small, andmicro cap stocks? The investment managementcommunity wants you to think that those are validasset classes too. If they can convinceyou that these are all distinct and importantasset classes, then they can argue that youshould hold some of each in your portfolio. Andwho better to do all this slicing, dicing, and cookingfor you than they—at a high price, of course.

As it turns out, all this superfine slicing anddicing is probably not worth it, because it isn'tclear that over time these finely defined assetclasses show significantly different characteristics.It's a good idea to stick to the following assetclasses on the stock side for your portfolio: largecap stocks, large cap value stocks, small capstocks, small cap value stocks, real estate investmenttrusts, and foreign stocks. On the bondside, you may want to consider short-termbonds, Ginnie Maes, and long-term bonds.

Although this is a much smaller number ofasset classes than the investment managementcommunity would want you to consider, recognizethat for all but sophisticated investors, jugglingeven this many asset classes may be too much. Ifyou're shooting for the simplest possible approach,hold just 1 US Total Market Index fund, a short-termbond fund, and maybe an international stockindex fund with an investment in money marketfunds thrown in for emergencies.

How much penalty in returns would you pay forthe simplicity? No one can tell for sure, but it'sprobably between 0% and 2% per year. Over thelong term, this can mean leaving a lot of money onthe table. But if you join the full-fledged asset classwarfare without knowing for sure what you'redoing, you can end up paying a heavy price.

Chandan Sengupta, author of The Only

Proven Road to Investment Success (John Wiley; 2002), currently teaches finance at the

Fordham University Graduate School of Business and consults with individuals on

financial planning and investment management. He welcomes

questions or comments at chandansen@aol.com.