The Mathematics of Money

Copyright © 2008, The McGraw-Hill Companies, Inc.

Investment professionals often speak of asset classes, a term for general categories of similar

investments. The three main asset classes are equities, fixed income, and cash. “Equities”

are investments that represent ownership of businesses – essentially, equities means stocks.

“Fixed income” investments provide a set stream of payments to their owners. This class can

include corporate and government bonds, as well as mortgages and long-term certificates of

deposit. The term “cash” can be a little misleading. It does include the usual meaning of cash,

dollar bills in you wallet, but it also is taken to include short-term investments with little or no

risk, such as bank accounts, short-term certificates of deposit or government bonds, and short-

term corporate bonds of companies with very solid credit ratings.

These three asset classes differ in terms of both the degree of risk they carry and the rates

of return they have historically tended to earn. Not surprisingly, the very low risk investments

in the cash asset class do not offer particularly high rates of return. The somewhat riskier

loans included in the fixed income asset class tend to offer higher rates of return overall. This

only stands to reason; if a higher risk investment could not be hoped to produce a higher

return than a lower one, there would be no incentive for any sane investor to put money into

the riskier class. Finally, equities offer the greatest potential for both price volatility and risk,

but they compensate for this by offering the greatest potential for investment gains.

There is quite a bit of controversy about the rates of return that can be expected from each

asset class overall. Of course, there is a great deal of diversity among the investments included

in each of these broad classes, and there is no definitive way to decide just what should be

included in each of these classes. Should we base equities only on the stocks of solid, established

American companies or should we include smaller, higher risk, less established businesses?

Should we include foreign stocks or not? It should be apparent that a portfolio restricted to

large, well-established (so called blue chip) company stocks would be expected to behave

differently from a portfolio that also includes developing biotechnology companies and Viet-

namese nanotech solar panel manufacturers. Should the fixed income class be based only on

investment-grade bonds, or should junk bonds be included? How about foreign bonds? How

much should be based on short-term bonds, and how much on long-term?

The values given in the table below are intended to be a reasonable representation of

the long-term average rates of return from each of these classes in the United States. They

offer a range of commonly cited figures based on the past, not the future. Even if we all

agreed on what mix of investments to use as the basis for each category’s overall average

risk and return, no one can know what the future returns will be on any investment or class

of investments. Also, no one can know in advance whether any given selection of invest-

ments from an asset class will perform better or worse than the overall average return for

investments of that type. Taking all of this into account, it is still reasonable to use these

figures as a basis for an assumption of what might be reasonable to expect.

Asset Class

Degree of

Risk

Historical Average Rate

of Return

Cash Minimal 2–5%

Fixed Income Moderate 4–7%

Equities High 8–12%

Do not misunderstand the ranges shown in this table. The 8–12% range shown for equities

here does not mean that, in each year, equities can be expected to return between a low of

8% and a high of 12%. This is absolutely not the case; there have been many years when

equities returned less than 8% or more than 12%. The 8–12% range means that, depending

on what sorts of equities you include and how long a historical period you look at, the long-

term average rate of return would probably fall somewhere between these two values.

Asset Allocation

How an investor decides to divide a portfolio among different asset classes is referred to

as asset allocation. An investor looking to achieve the highest overall rate of return might

6.4 Mutual Funds and Investment Portfolios 293