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10 things every investor should know about asset classes

Reprinted courtesy of MarketWatch.com.

To read the original article click here

The best single piece of advice I have for investors is deceptively simple: Diversify, diversify, diversify.

It’s simple, a one-word prescription. But it’s also deceptive, because it works only if you do it intelligently.

Everything I’ve learned over half a century makes me believe that asset-classes are the key to long-term success. Choose the right ones. Avoid the wrong ones. Mix them up properly, then leave them alone and let them work for you.

In my signature article, I identify and discuss the best asset classes for long-term performance, show why each one matters, and tell how to put them together. I call the result “The Ultimate Retirement Investment Strategy.”

Here are 10 things every investor should know about asset classes:

1: Past performance

Every important asset class has a known, factual history of performance. Each one also has a future, which cannot be known. Don’t forget that last bit.

2: Risk

Every asset class — in fact, every investment — involves risk, which is another term for uncertainty. This is where things get tricky, because there is no risk in the past, no uncertainty about how things turned out.

Yet it’s essential to evaluate risks, because they can help us predict future losses (which of course we investors always hope will be temporary). Knowing past losses, we can try to predict whether we as investors are likely to accept similar losses and stay the course in search of expected long-term gains.

3: Long term vs. short term

Longer-term results from the past are likely to be a better guide to the future than shorter-term results. To use an extreme example, the performance of the U.S. stock market over the past 10 years is a better guide than whatever has happened to the Standard & Poor’s 500 Index SPX, +0.41%  during the most recent three hours of trading.

4: One asset class vs. all

Predicting the long-term performance of just one asset class is harder than predicting the performance of a group of them.

Even when most sectors of the market are moving up or down, there’s usually some outlier that’s bucking the trend. Because there’s no way to know in advance what that outlier will be, the best strategy is to own them all.

5: Best asset classes

You don’t have to have luck or genius to choose the best asset classes. What you need is long-term past performance data identifying the asset classes with favorable performance and acceptable levels of risk.

Among equity asset classes, I recommend 11: U.S. large-cap blend, U.S. large-cap value, U.S. small-cap blend, U.S. small-cap value, U.S. REITs, international large-cap blend, international large-cap value, international small-cap blend, international small-cap value, international REITs and emerging markets.

6: Research

I didn’t originate that list. Those 11 asset classes were identified based on decades of data and legions of academic researchers.

I’ll take responsibility for being the messenger and for trying to teach as many people as possible how to put those asset classes together into effective portfolios.

7: Dumb luck

Despite the best research, the best strategy and the best execution, dumb luck can play a significant part in how these asset classes perform in the real world.

For example:

  • The best 40-year return for U.S. large-cap value stocks occurred from 1958 through 1997, when they compounded at 15.7%. A $5,000 annual investment would have produced an ending value of $10.8 million.
  • The worst 40-year return for that asset class occurred from 1930 through 1969, with a compound return of 8.3% and an ending value of $1.4 million.

If you were a 40-year investor, you didn’t have a choice about which year you started. It was just good luck or bad luck. (Also notice that there were some overlapping years in those two periods – 12 to be exact.)

8: Get to know each asset class

It pays to understand the asset classes in which you invest. That will help you stay the course through the inevitable bad times.

To use just one example, when everything is doing well except emerging markets stocks, you may be tempted to dump them as dogs. In the short run, that might feel good, but in the long run it would probably be a mistake, because emerging markets stocks have huge long-term growth potential.

During such times, your resolve will be much stronger if you understand emerging markets well enough to remind yourself why you invested in them in the first place.

9: Index vs. managed

Every asset class I recommend is represented by actively-managed funds and at least one index fund. The actively-managed funds won’t necessarily give investors the results of the asset class, and they will be more expensive and less tax-efficient.

The best way to achieve the results of any asset class is to invest in the best index fund that tracks it. I recommend Vanguard’s funds.

10: Help is on the way

Asset-class help is on its way to you. Starting next week I will focus, one by one, on my 11 recommended asset classes. These articles will include long-term performance and risk factors, the rationale for believing each one has a promising long-term future, and the best way to capture that future.

I’ll show you how to put them together and how to control your level of risk. This series of articles will cover a lot of the material that’s taught in a course at my alma mater, Western Washington University.

The tuition for these articles is free. The payoff can mean millions of extra dollars in retirement. I hope you’ll come to class and follow along.

For more on asset classes, check out my podcast.

Richard Buck contributed to this article.