Acceptable and Unacceptable Assets

Once you have completed your investor profile, the next step is to determine acceptable investment options.

What asset classes and sub-classes to include in or exclude from your investment universe.

Your unique profile and risk tolerance should determine which assets to invest in.

Today I will offer a few thoughts on things you might consider.  

Core Asset Classes

There are three core asset classes in which individuals traditionally invest their money: cash, fixed income, common shares.

Previously, we have considered each in some detail.

For a review of cash, please read Cash and Cash Equivalents and Money Market Instruments.

For fixed income, please read Bonds, Notes, and Debentures and Preferred Shares.

For common shares, the post Characteristics of Common Shares may be useful.

Core Asset Subclasses

Within each of the core asset classes, there are a variety of subclasses.

It is important to understand and differentiate between the subclasses. The core classes may have general risk-return characteristics. But within the class itself, these characteristics can change significantly.

In a subsequent post, I shall provide examples of differing risk within a specific class.

Within the core classes, you should consider the following:

Countries

Are there countries or regions that you wish to focus on or to completely exclude?

Perhaps you grew up and worked in Brazil. You might have a better understanding of investments in that country and that may give you a competitive advantage.

Perhaps you live in a country which has investment restrictions on another country. For example, many countries currently have sanctions against dealing with Iran and North Korea. Even if you wanted to invest in these places, it might be difficult to do so legally.

Perhaps there are countries that do not easily allow foreign investment. While it is getting easier, foreigners have to jump through a few hoops to invest in mainland China. China A shares come to mind as a difficult direct investment for foreign individuals.

Perhaps there are countries that you do not want to invest within due to personal beliefs. During Apartheid, many countries and individual investors excluded South Africa from their investment portfolios and trading.

Industries

The points I made with countries are also applicable to industries.

Many individuals believe smoking is evil and refuse to invest in tobacco industry companies. Pacifists may want to exclude companies that operate in the military areas. And so on.

As well, today there are many socially responsible investors. They actively seek out environmentally friendly and/or socially conscious companies in which to invest their capital.

There are many investment funds that cater to socially responsible and green investors.

With industries, consider areas where you have specialized knowledge. If you work in the mining industry, you might be more comfortable assessing companies in this field. As such, it might be an area in which you wish to focus.

Nonsystematic Risk Levels

Within an asset class, individual investments may have relatively higher or lower risk than the class itself.

Do you want to include or exclude higher risk investments?

If so, what is your threshold?

Consider fixed income long-term bonds. Most investors only consider investment grade debt. But if you have a lower or higher risk appetite than most investors, you might want to further limit or expand your debt investment options.

For example, Moody’s breaks down long-term debt into 21 possible ratings. Most investors invest in debt rated Baa3 or higher, investment grade debt. If you are extremely risk averse and only want to invest in the top rated debt, you need to limit your investments to Aaa rated instruments. But if you want to severely speculate, you can invest all the way down to Ca or C rated bonds. Debt that is in default and likely will not recover to pay off creditors.

Investment Styles

We looked at different investment styles already.

Growth versus value. Active versus passive. Dividends versus capital. Market capitalization – large versus small. Domestic versus global. Funds versus shares. To list a few.

Are there styles you like and wish to utilize?

What about styles that make no sense to you?

Perhaps you believe value investing is right for you and that growth strategies are too risky.

Or perhaps you want to focus on nano-cap stocks and have no interest in the mega-cap sector.

Your investment philosophy may lead you to include and exclude certain styles.

Taxes

Investment returns are typically taxed in different ways. In many countries, there is one effective tax rate for interest, another for dividends, and a third for capital gains.

Depending on your income and tax situation, you may want to concentrate on one type of investment and ignore another.

Alternative Asset Classes

Traditionally, investors focus on these three core asset classes.

But obviously there are other asset classes that merit investment consideration. Once we have covered the core classes, we will review non-core investment options.

Inclusion or exclusion in one’s portfolio of alternative asset classes will depend on three key variables: the investor’s unique profile, especially risk tolerance; understanding of the product and its place in the portfolio; comfort and ability to properly trade these alternative assets.

Hopefully that provides some guidance in assessing assets to include in and exclude from your portfolio.

We will look at the core asset subclasses a little more next week.

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