For most of us, the refrigerator is a hugely valuable (if underappreciated) appliance. Like a refrigerator, a cooler is designed to keep items cold. However, it is portable and allows us to go to the beach, pool, or tailgate. Of course, thermally insulated cups are also portable and have become so popular that many car manufacturers have increased the size of cupholders to accommodate this latest beverage trend. The refrigerator, cooler, and cup all accomplish the same objective under different conditions (but are each appropriate for different circumstances). They are not completely interchangeable even though they are all designed for the same purpose. It is much simpler to put food in a cooler as you head to the beach instead of bringing your refrigerator from home with thousands of feet of an extension cord. This may seem obvious. However, many investors treat their investment portfolio as if all asset classes are interchangeable. Without thinking about it, they may simply expect all investments to “grow”.
There are many different asset classes available to a US investor. The most common of these options are currencies, fixed income, and equities. Structured products, real estate, and commodities are less common but still a part of many portfolios. Even rarer are assets such as collectibles or infrastructure or investments in private transactions. It is fair for us to expect every one of our investments to increase in value over periods. However, it is worth noting that investments increase in value for a variety of reasons. Understanding where this increase in value will come from and how this increase in value has historically performed in certain economic conditions allows a savvy investor to benefit from asset class selection.
Let’s start with the basics. An asset will increase in value if investors perceive that the asset will be worth more in the future or if the asset produces a regular cash flow. Imagine that you hold the stock of a certain company and one day that company announces that it has found a cure for cancer. The value of that stock is likely to increase. Even though the company has not produced any new cash flows a realistic expectation now exists that this company will produce larger cash flows in the future. The value of this company would rise based on the public perception that the company will be worth more in the future based on this discovery. The primary reason to hold any asset is the steady cash flow produced by that asset. Interest, dividends, and rents are all examples of how common asset classes produce value for an investor.
To be a suitable investment, we should assume that our investment will produce a regular cash flow from dividends, interest, or rents. Let’s think of these cash flows as the “drivers of returns”. According to a paper produced by The Hartford Funds, over the last 50 years, 84% of the total return of the S&P 500 can be attributed to reinvested dividends and the power of compounding.¹ While dividends have been a primary driver of returns for equities, interest payments are likewise the primary driver of returns for any investment in fixed-income investments. Similarly, “rents” are the primary way in which owners of real estate make money.²
One of the most important considerations for any investor should be how closely correlated these “drivers of returns” are to each other. Additionally, it is critical to understand how each cash flow would be affected by a change in a specific economic condition. Would all these cash flows be negatively impacted by a weaker US dollar or by a tumble in emerging markets? Ideally, an investor has cash flows from investments that would react differently from each other as economic conditions change. For instance, using a tool provided to us by BlackRock³ we find that if the 10 Year US Treasury Rate was to rise by 1% we might expect to see the following asset class reactions:
While some of the asset classes increased in value some of them lost value. None of them adjusted by the exact same percentage because their cash flows are all affected differently and to different degrees by the same change in the US Treasury Rate. We see this repeated throughout different “stress tests” that we run on portfolios. If inflation expectations rise or stock market volatility increases these scenarios affect the underlying cash flows of our asset classes differently.
This is important because it is easy to believe that a portfolio is diversified simply because it contains different investments. However, if the cash flows that support the value of multiple assets would all be affected in the same manner and to the same degree by a change in an economic condition then there is no benefit to this diversification. By understanding how different asset classes are uniquely affected by changes in economic conditions, a thoughtful investor will be able to use asset classes to protect cash flows and increase growth in their portfolio.
You may not need to ask your financial advisor whether to take a cooler or your deep freezer to the beach, but it is probably a good idea to get their insights into your investment portfolio.
¹The Power of Dividends Past, Present, and Future – Hartford Funds
³BlackRock Aladdin Stress testing results (%) represent the potential impact of discrete market events on the selected portfolios and asset classes. Asset classes may be represented by a relevant iShares ETF selected by BlackRock. The iShares ETF may have different characteristics than an index used to represent an asset class due to, in part, differences resulting from the ETF’s tracking error.