Making sense of asset classes
An asset class is a group of investments that share similar characteristics such as risk and returns. This guide will help you make sense of the major asset classes: Equities, Fixed Income, and Real Estate focusing on historical returns and expected returns going forward. Understanding what drives returns for the different asset classes is extremely important for improving your investment decisions. Otherwise, how will you know how much of your portfolio to invest in equities (stocks), fixed income (bonds) or in real estate. This analysis is influenced by the book “Expected Returns” by Antti Ilmanen. llmanen has had a distinguished career at several well-known hedge funds and the Central Bank of Finland. I’ll save you the trouble of reading this insightful 568-page book and distill the lessons down into actionable items for your investment portfolio. This guide also draws heavily on my own investment experience. Over time, we will add alternative asset classes such as Hedge Funds, Private Equity, Cryptocurrencies, and provide examples of how to analyze individual stocks, bonds, and real estate. Stay tuned!
While investing can sound complicated, investment returns are largely driven by two factors: cash flows you receive such as dividends, interest income or rental payments, as well as an increase or decrease in the price of the asset. Those are really the two major drivers of investment returns over time. The chart below shows annual real returns for equities and bonds from 1900-2019 on a global basis as well as for select countries. The chart also shows you how volatile returns have been (standard deviation) as well as the worst and best years for returns for each country. Throughout these primers we will focus on nominal and real returns. Nominal returns are the actual return you received on an investment, while the real return subtracts out inflation from the nominal return. For example, if you own a stock that appreciates from $100/share to $109/share over the course of one year, your nominal return is 9%. However, if inflation was 2% during that time frame then your real return on that investment was 6.9% (1+9%)/(1+2%). This is a critical concept as real returns are a more accurate reflection of your actual purchasing power and wealth than nominal returns.
Real (inflation-adjusted) equity and bond returns, 1900-2019
