This post is part of Smart401k CEO Scott Hollsopple’s contribution to the U.S. News & World Report Smarter Investor blog series. To view the original article, click here. Original post date September 11, 2012.
If you’re trying to decide which asset classes belong in your account—and what percentage of your portfolio each asset class should be—it helps to understand how various asset classes tend to behave.
International Equity Funds
There are several asset classes contained within the international equities fund category because these funds can invest in small-, mid- and/or large-cap companies headquartered outside the U.S.
International funds that focus on developed economies are able to take advantage of currency variations. If the dollar weakens, these funds could strengthen.
Developing economies don’t have the same reporting and regulatory requirements that we have in the U.S. and other developed economies. For that reason, their economic and corporate data are more difficult to measure, making performance projections more difficult. These factors alone cause volatility.
Typically, we’d expect developing countries to be hit harder by downturns in the world economy because they tend to be reliant upon exports (i.e., when the economy struggles, larger, more established countries buy fewer exports from developing countries with lower costs.). Similarly, an uptick in consumption could cause a company from the developing world to take off, and global economic growth could produce amplified returns across an emerging economy.
Real Estate Funds
Real estate funds primarily invest in equity REITs and mortgage-backed securities. Typically, they have a low correlation—so they behave differently—to bonds and equities, and could be a worthy diversifier for a portfolio.
Commercial real estate investments often perform well during times of inflation since commercial rents rise as prices rise. These investments often reflect the overall strength of the economy, though reactions are often delayed. For example, consumer spending may slow for a while before we see a pullback in the commercial rental space. Commercial real estate is also affected by construction, as more commercial space can lead to lower prices and less rental income.
Small- and Mid-Cap Funds
In a recovery, growth funds tend to outperform value funds. In a slump, the reverse is often true. That applies to all equities, but the effect is magnified in small- and mid-cap funds, compared with large-cap funds.
Small- and mid-cap companies are less stable by virtue of their size. They’re often younger companies, in an earlier stage of their growth cycle, that magnify economic trends. We see more volatility with these stocks, but we can see explosive growth under the right circumstances.
Funds focused on large, blue chip American companies are less volatile than other equities funds. Their stability through volatile times is their fundamental appeal. For income investors, these companies also have the capacity to pay larger dividends than smaller companies.
Bonds offer a nice counter-balance to equities because these two investment categories have historically had low correlation. While equities often rally when interest rates rise, bonds do well when interest rates are decreasing, which typically corresponds to a weak economy—people move to bonds when they are worried about economic growth. Typically, the Federal Reserve works to decrease rates in the face of a weak economy to boost demand for loans and as a result increase consumption which is supposed to help the economy get back on track.
Cash equivalents are a stable, low-volatility part of a portfolio. These investments are fairly liquid. When interest rates are low, as they are now, cash equivalents offer very little in the way of returns. When interest rates are higher, these offer some yield in addition to low volatility and safety.
Knowing there are some mixed predictions for the economy as we move toward the final quarter of 2012, it’s best to stick with your long-term investing strategy based on your needs and investing tolerance. Stay invested and diversified, and keep contributing to your 401(k) account.