Dear riders,

As you probably noticed, I decided to have a top-down approach to financial markets. In the past weeks we learned about economic cycles, economic booms and recessions. We saw that financial markets are not always a perfect representation of the economy, especially in time of crisis, and policymakers tend to save the owners of financial assets. Therefore all assets are not equal: their risk and return profile change with the economic environment.

In this article we continue to “zoom in” and talk about asset classes and, in particular, multi-asset class portfolio. We will use this material in the future in order to construct a more balanced, diversified and robust portfolio.

Summary:

  • How to make money investing?
  • Asset classes and risk profiles
  • What is a multi-asset class portfolio?

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How to make money investing?

Financial markets are complex systems: there are many ways of building a portfolio, many strategies, many products and type of investors. However there are only two ways to make money when we invest in an asset:

  • We take cash distributions (such as dividends or interests)
  • We sell our asset to someone for a higher price than you paid for it (capital gain)

Therefore two factors drive asset prices:

  • The expected cash distribution
  • Investors' relative preference for different cash flow profiles

We end up losing money when cash distribution is lower (or pushed further in time) than we expected or when we misjudge investors' relative preferences for different cash flow profiles.

That's it. That’s the assumptions we embed in our investment decisions.

And guess what? Changes in the economic environment influence investors’ preference for different cash flow profiles. Understanding how professional investors’ respond to economic cycles and market regimes is key to predict (or at least understand) asset price movements.

Even though it is hard (or impossible) to predict stock picking decisions made by professional investors, it is easier (if not trivial) to predict their preference for different asset classes.

Asset classes

Investments assets can be tangible or intangible and are bought and sold by investors in order to generate additional income.

An asset class is a group of securities (i.e. negotiable financial instrument) that exhibit similar characteristics and are subject to the same law and regulations. Equities (stocks), fixed income (bonds) and cash equivalent are three main asset classes.

Each asset class is expected to have different risk and return investment characteristics and to perform differently in a given market environment.

Asset classes by risk profile

I arranged an almost exhaustive list of asset classes by risk and return profile. Growth assets refers to riskier assets with larger potential returns. Defensive assets is more conservative while moderate assets is an intermediate.

Growth Assets

Commodities Basic goods used in commerce such as grains, gold, oil or natural gas.

Emerging Market Bonds A fixed income debt issued by countries with developing economies as well as by corporations within those nations.

Equities Ownership of a (in our case publicly listed) company.

Cryptocurrencies Digital asset designed to work as a medium of exchange and/or a store of value.

High Yield Bonds Bonds that pay higher interest rates because they have lower credit ratings and investment-grade. They are more likely to default.

Property

Infrastructure

Moderate assets

Government Bonds Long Dated Debt issued by the government with a 10 to 30 year maturity. Such as Treasury Bonds (T-Bonds).

Credit The credit market allows to invest in corporate or consumer debt. (e.g. Apple Inc issued $1billion in bonds in 2017 that mature in 2027).

Defensive Assets

Cash equivalents Investments that can readily be converted into cash.

Government Bonds Short Dated Debt issued by the government with a 1 year or less maturity. Such as Treasury Bills (T-Bill).

Each asset class belongs to a risk profile, and contains multiple assets. From macro to micro we get: risk profile -> asset class -> asset

Examples:

Growth -> Commodities -> Oil
Growth -> Equities -> Microsoft
Moderate -> Government Bonds Long Dated -> Treasury Bonds
Moderate -> Credit -> Apple Inc bonds
Defensive -> Cash equivalents -> Foreign currency
Defensive -> Government Bonds Short Dated -> Treasury Bills

What is a multi-asset class portfolio?

As its name states, a multi-asset class portfolio contains more than one class of assets.

Risk profile weights, and asset class weights are macro-parameters of the portfolio, they are chosen by the investor with respect to the economic environment, the market regime and its own perception of risk (and risk aversion). Professional investors make big-picture decision and balance asset classes to achieve particular investment outcomes (putting more weights on the most suitable risk/return profiles for the particular economic environment).

Rookie investors tend to be all-in in their favorite stocks. Therefore when the economic environment is changing they can find their supposedly diversified portfolios have a correlation move to one, and have only a few options available to reduce their exposure to the market. Meanwhile professional investors, who are invested in multiple asset classes, will re-balance their classes of assets (and stocks allocations). They take advantage of the diversity of asset classes.

Multi-asset investing recognizes that global markets are interconnected and create a more nimble and broadly diversified portfolio. They also reduce volatility compared to holding only one class of assets.

Some risk profile allocation examples

The ball game is: More Growth When It’s Safe, More Defensive When It’s Not. That’s it. We will cover later how to know when it’s safe or not, and how to invest in each phase (in particular in times of crisis). We assign, to each risk profile, an adjusted over time weight in order to preserve the capital value of the portfolio.

Let’s take some general examples just to get the idea.

Bull market, safe environment

During a bull market, with low risk and low volatility, an optimistic and favorable environment, your asset mix would look like this:

Euphoria, uncertain environment

In time of euphoria and uncertainty, when the market starts to call for a bubble, and metrics become uncertain. You would adopt a more defensive asset mix.

Crisis, high risk environment

During a crisis (like right now), and until things settle down, it is probably a good idea to be very defensive.


That’s all for today! You didn’t fully grasp the idea yet? Don’t worry next (and the following) week we will cover more specific examples.

Also, if you have any question or feedback: leave a comment :)

See you next week!

Kevin from Hook


Further readings:


This newsletter does not provide investment advice
As always, trading activity is risky and exposes you to loss of capital. Never invest more than you can afford to lose. Never. The information presented on this page (and every other) are not investments counsels. Your use of this content is at your own risk. The content is provided “as is” and without warranty of any kind, either expressed or implied. All views and opinions expressed here are the author’s own, and are not representative of the views of any current, past or future employer.