Do You Own Enough Asset Classes?

K.

Have you ever asked someone for aspirin, only to have them offer you ibuprofen instead? Sure, aspirin and ibuprofen work similarly, but they're not exactly the same thing.

Like "aspirin," the term "asset class" is often used beyond its narrowest definition. Technically, K.'s first suggestion is the best: "Asset class" typically refers to highly distinct types of investments. The major asset classes are generally agreed to be stocks, bonds, cash, real estate, and commodities.

However, financial professionals tend to use the term "asset class" more liberally. I often hear fund managers refer to small-cap stocks as an asset class. I've heard emerging-markets bonds called an asset class. The same can happen with convertibles or high-yield bonds.

For investing purposes, though, it's probably best to think of asset classes as broad, distinct types of investments. For most investors, stocks, bonds, and cash are the three you need to worry usually about when building a portfolio, and they're the ones we'll talk about here.

From a financial-planning standpoint, asset allocation decisions are some of the most basic and important ones you can make. In order to determine your appropriate asset mix, you should consider what your investment goals are, how long you have to achieve them, and how much risk you can handle. If you're in your 20s and saving for retirement, you will probably want to allocate the majority of your assets to stocks or stock funds. Why? Stocks are risky investments, but their returns over long periods of time tend to be higher than bond returns.

On the other hand, if you're five years away from retirement, you probably want the majority of your assets in bonds, and a smaller amount devoted to equities. Bonds--especially higher-quality bonds--offer the potential for a moderate return and reasonable volatility. And if you're saving to buy a house in a year, you probably want to put the money in a low-cost money market fund or ultrashort-term bond fund. (For more on near-term investing goals, see my article on the subject.)

Morningstar's  Asset Allocator can be used to help you assess whether your asset mix offers you a decent chance of reaching your investment goals. Start by selecting one of your own stored portfolios or Morningstar's standardized portfolio. Input the size of your current investment, the amount you intend to add every month, and the amount you hope to have at the end. You can then adjust the time bar, which designates the number of years until you expect to reach your goal, and the portfolio asset mix. The graph at the top indicates the likelihood that you will reach that goal given your particular parameters.

One thing you'll notice is that the portfolio asset mix is divided between cash, bonds, and three different kinds of stocks (foreign, small-cap, and large-cap). Distinguishing among three different kinds of equities obviously goes outside our original, strict definition of "asset class," but it allows for finer-grain asset-allocation decisions. In particular, small-cap stocks tend to be quite volatile, so it can be useful to understand how a small-cap-heavy portfolio's performance can differ from a large-cap-dominated one. And investors often want to know how much they have in foreign versus U.S. stocks since overseas' markets don't always trade in tandem with American bourses.

Deciding on basic asset allocation decisions can be a great first step to building a diversified portfolio. For more information on the subject of asset allocation, check out the portfolio section of Morningstar's Investing Classroom.