At some point, anybody with an investment portfolio such as an IRA or 401K has seen a pie chart showing how much equity, fixed income, cash, and maybe alternative investments they have in their portfolio. Depending on the asset allocation they are considered aggressive, moderate, or conservative. What does that mean though? Let’s break each part down.
Equity within the asset allocation represents ownership of something. A person has equity in their house if the house is thought to be worth more than what they owe on it. If a person owns part or all of a business they are said to have an equity share. A share of stock is a small sliver of ownership in a large company. Generally speaking, equity investments have been the greatest creator of wealth for investors. Of course, greater upside means greater downside. If the rental market is sluggish, or GDP growth is not what is expected, the value of equity is going to drop. Because of the risks that investors take by investing in equity, the more equity in a portfolio the more aggressive it is.
The other large portion an asset allocation chart is usually fixed income. Fixed income is a little deceiving I believe. Debt is a more appropriate name for this portion of the portfolio because fixed income portfolios primarily invest in bonds, which are a form of debt. Essentially what that means is that the investor is lending somebody money. When someone lends money to someone they have recourse if things go belly up. Having recourse and being guaranteed a stream of income makes bonds and other “Fixed Income” generally thought to be safer than equities. By safer, I mean that the returns are often less than equities in the long run, but they tend not to change in value as much in short-term.
Alternative Investments. I have seen The Big Short where they talk about synthetic this and derivatives of that… It didn’t end too well… While those are considered alternative investments, alternative investments are anything that doesn’t fall into the bucket of equity or debt. The point of an alternative investment usually is to have exposure to something the will move in contrast to equities and debt, so when the rest of the portfolio drops (and it will at some point) at least something else moves up. The most popular alternative investment I have seen is gold. Gold, unlike equity or debt, does not produce any cash flow. All gold does is sit there and look pretty, but that is kind of the point. If the housing market crashes, if the US is delinquent on its debt, gold will still be pretty.
Featured Image Credit: Jon Scally