Asset class investing involves the construction of share portfolios that reliably deliver returns of specific asset classes, ie. groups of securities that share common risk and return characteristics – large, small, growth and value stocks.
We know from historical data and the use of empirical evidence that tilting portfolios towards value stocks and small cap stocks provides higher expected returns.
There is a size effect and a value effect, which determine over 80% of portfolio returns.
We know that shares have higher expected returns than fixed interest, small company stocks have higher expected returns than large company stocks and lower priced value stocks have higher expected returns than higher priced growth stocks.
So, we can build asset class investing portfolios that target risks attached to value and small cap stocks and over an extended period of time can achieve a level of return commensurate with the amount of risk taken by an investor based on their particular risk profile.
We use cash and fixed interest investments inside a share portfolio to diversify risk ie. to act as a volatility dampener.
The role of diversification is to limit portfolio risk as much as possible without sacrificing a desirable level of expected return.
We take a fairly passive approach to investing, but can act quickly inside a portfolio if we need to if the risks are not worth taking.
Although we can’t control financial markets, what we can control in the investment process are investment costs and asset allocations.
