In the asset accumulation chapter I use the terms pillars and assets interchangeably because both refer to repositories of value. In practice, the investments we undertake within our stock and bond pillars are categorized into what are known as asset classes.
An asset class is a collection of assets that share certain risk and return characteristics. Some examples are: a collection of large American stocks, a collection of US Government-issued bonds, or a real estate portfolio of shopping malls. This categorization makes it easier to create funds dedicated to investments in similar assets with predictable risk and return characteristics.
Investors buy funds matching their risk and return preferences. Passive investors buy funds that provide broad diversification with low fees. These are often referred to as indexed funds—those that mimic the returns of broad, diversified indexes such as the S&P 500 index of large American company stocks.
The basic asset classes are stocks, bonds, and cash. Some investors also include real estate in this category. There are also non-basic asset classes, known as alternative asset classes, which include commodities, private equity, venture capital, and hedge fund investments. Alternative asset classes often seem glamorous, but they tend to be very risky and require more specialized knowledge.
There are various subcategories of basic asset classes. The stock asset class may be further divided into sub-asset classes known as: large company stocks (Large Cap), medium sized company stocks (Mid Cap), small company stocks (Small Cap), and emerging market stocks. Bonds may be divided into: investment grade (safer) bonds vs. junk (riskier) bonds. All of these may be subdivided even further, for example, by country or industry.
As we’ll see later in this chapter, investments in these asset classes come in the form of funds (mutual funds or exchange trade funds (ETFs). Investment funds are available for just about every imaginable sub-asset class. Want to invest in French Aerospace? There’s probably a fund for that. Want to invest in American agricultural firms? there’s a fund for that. More interested in Canadian bio-tech? All you have to do is search and you’ll probably find some investment to match that preference. These specialized funds lack one important element sought-after by passive investors—they aren’t diversified. Generally, the more specialized the fund, the higher its fees and the greater your risk exposure. Passive investors don’t chase specialized funds. Instead, we stick with basic, low-fee, diversified ones.
A single pillar may include investments in several asset classes. A stock and bond pillar in the form of a 403(b) retirement account, for example, will typically include investments in domestic (American) Large Cap stocks, Mid Cap stocks, Small Cap stocks, as well as emerging (foreign) market stocks, investment grade bonds, etc. Your children’s college savings plan pillars also include investments in stock and bond asset classes.
Across all your pillars, your objective as a passive investor is to invest in a diverse set of asset classes.
Pursue the broadest diversification you can. Diversify across sectors, industries, geographies, etc.