What Is an Asset Class?
There is no universally accepted definition. Some describe it as a financial asset with certain cash flows. But then commodities wouldn’t qualify. So maybe an asset class has to pay a risk premium. But then cash and money market investments wouldn’t count either.
Here’s the definition I’ve been using: "An asset class is a group of assets with similar exposure to the fundamental drivers of the economy."
What are the economy’s fundamental drivers, and how do they influence different asset classes?
The economy has many drivers, but only a handful really make a difference. Those are:
- Human ingenuity
- is the drive to make things better over time. We ask questions and seek answers. This propels productivity growth as we strive to solve our problems and build a future that is better than the past.
- a society can hardly function without the space to feed, house, and employ itself. Hence, land — and its location — is a critical component of the economy.
- Resources and infrastructure
- is the human desire to want more of everything, money in particular. The urge to create more wealth out of existing capital is at the heart of the entire financial industry.
Mapping the Asset Classes and Their Fundamental Drivers
Every asset class can be mapped according to its exposure to these various drivers.
- Stocks, for example, are driven mostly by economic growth and human ingenuity. Stock returns are primarily a function of the economy’s rate of overall growth and how well entrepreneurs and businesses increase productivity and develop new products and services that people want.
- Government bonds are driven by the inverse of growth — slower growth, meaning higher bond returns through declining real rates — and inflation. And where there’s credit exposure, there is greed. After all, why else would we bother with corporate or high-yield bonds instead of safe government-backed Treasuries?
What It All Means
We don’t need many different asset classes in our portfolios. The deluge of “alternative” assets are mostly a rehash of exposures to these various fundamental drivers.
Many alternative asset classes aren’t truly different. This tends to become glaringly obvious when a crisis hits and all the “uncorrelated” alternative assets suddenly nosedive in tandem with stocks. So why not avoid such a painful realization?