Investment asset classes suitable for the passive long-term investor:
I am going to make some assumptions here, and not get into too much detail, but these are the asset classes I think are suitable for passive long-term investment:
1) Domestic Stocks - self-explanatory. They are liquid, exchange traded, and have a high long-term return albeit at some risk. I would break this down into large and small cap stocks, to provide diversification. Small caps tend to return more but have more risk (generally they do worse in bear markets).
2) Domestic Government Treasuries. Again, self-explanatory. Low-risk, low-return. They tend to do well in some situations - such as deflation, market panics, and recessions - where stocks typically get hammered. Thus they provide a valuable hedge against crisis situations. Also, in more normal times they provide predictable income and add stability to a portfolio.
3) Real estate. Fairly low correlation to stocks and bonds. Returns tend to be higher than bonds but lower than stocks, over the long-run. Nowadays ETFs allow one to invest in real-estate investment trusts (REITS) which broadly track the returns of national real estate markets. Real estate provides some income returns (due to rental income) and some equity-like capital appreciation (due to land scarcity, inflation). It thus provides a fairly good, albeit imperfect, long-run inflation hedge.
4) Foreign stocks, including blue chip G7, and emerging markets. Blue chip foreign stocks provide similar returns to domestic stocks, whilst also not being totally correlated. They thus reduce overall volatility whilst not reducing returns - a classic diversification free lunch. Emerging markets are higher risk but over the long-run ought to provide higher returns to compensate. They are even less correlated, another bonus.
5) Commodities. These provide a pretty low real return over the long-run, however they do have the great benefit of having very low, possibly even negative correlation to the stockmarket. In certain circumstances, such as low growth high inflation scenarios, or wars, they do extremely well whilst other assets like stocks, bonds, and/or real estate get hit hard. A small commodity allocation should reduce portfolio risk and provide diversification, whilst not reducing overall returns that much.
6) Treasury inflation protected securities (TIPS). Just like treasuries, except they have a cast-iron inflation hedge so are even lower risk. An essential part of the fixed-income portion of any portfolio.
Asset classes that I would not recommend:
1) Corporate bonds. These provide more risk than treasuries, without much extra return. More importantly, in crisis situations they become illiquid and correlated to stocks, so their bear market protection is poor.
2) Junk bonds. Same problems as corporate bonds, but even worse.
3) Actively managed funds. Data shows higher fees, higher taxes, higher transactions costs, more volatility and lower performance for most active funds compared to index-trackers.
4) Unlisted investments such as hedge funds, private equity. I do not think the typical investor has the resources to screen funds/firms, and keep tabs on subsequent performance. They are also illiquid and have high fees. For non-experts/pros, I would steer clear and stick to the much lower risk exchange-traded asset classes.
Now, onto the expected long-run returns of these asset classes...
I am going to make some assumptions here, and not get into too much detail, but these are the asset classes I think are suitable for passive long-term investment:
1) Domestic Stocks - self-explanatory. They are liquid, exchange traded, and have a high long-term return albeit at some risk. I would break this down into large and small cap stocks, to provide diversification. Small caps tend to return more but have more risk (generally they do worse in bear markets).
2) Domestic Government Treasuries. Again, self-explanatory. Low-risk, low-return. They tend to do well in some situations - such as deflation, market panics, and recessions - where stocks typically get hammered. Thus they provide a valuable hedge against crisis situations. Also, in more normal times they provide predictable income and add stability to a portfolio.
3) Real estate. Fairly low correlation to stocks and bonds. Returns tend to be higher than bonds but lower than stocks, over the long-run. Nowadays ETFs allow one to invest in real-estate investment trusts (REITS) which broadly track the returns of national real estate markets. Real estate provides some income returns (due to rental income) and some equity-like capital appreciation (due to land scarcity, inflation). It thus provides a fairly good, albeit imperfect, long-run inflation hedge.
4) Foreign stocks, including blue chip G7, and emerging markets. Blue chip foreign stocks provide similar returns to domestic stocks, whilst also not being totally correlated. They thus reduce overall volatility whilst not reducing returns - a classic diversification free lunch. Emerging markets are higher risk but over the long-run ought to provide higher returns to compensate. They are even less correlated, another bonus.
5) Commodities. These provide a pretty low real return over the long-run, however they do have the great benefit of having very low, possibly even negative correlation to the stockmarket. In certain circumstances, such as low growth high inflation scenarios, or wars, they do extremely well whilst other assets like stocks, bonds, and/or real estate get hit hard. A small commodity allocation should reduce portfolio risk and provide diversification, whilst not reducing overall returns that much.
6) Treasury inflation protected securities (TIPS). Just like treasuries, except they have a cast-iron inflation hedge so are even lower risk. An essential part of the fixed-income portion of any portfolio.
Asset classes that I would not recommend:
1) Corporate bonds. These provide more risk than treasuries, without much extra return. More importantly, in crisis situations they become illiquid and correlated to stocks, so their bear market protection is poor.
2) Junk bonds. Same problems as corporate bonds, but even worse.
3) Actively managed funds. Data shows higher fees, higher taxes, higher transactions costs, more volatility and lower performance for most active funds compared to index-trackers.
4) Unlisted investments such as hedge funds, private equity. I do not think the typical investor has the resources to screen funds/firms, and keep tabs on subsequent performance. They are also illiquid and have high fees. For non-experts/pros, I would steer clear and stick to the much lower risk exchange-traded asset classes.
Now, onto the expected long-run returns of these asset classes...
