Behavioral Finance and Investor Types: Managing Behavior to Make Better Investment Decisions

Chapter 12

Capital Markets and Asset Classes

Do not worry if you have built your castles in the air. They are where they should be. Now put the foundations under them.

—Henry David Thoreau

Understanding the basics of the capital markets, the asset classes one can invest in, and the risks associated with each is a critical step in building a proper investment portfolio. As reviewed in Chapter 14, asset allocation is the process of determining which asset classes one will invest in and how much of each will be included in the portfolio. The right asset allocation for a given investor will depend upon how well the allocation's characteristics and behavior match the client's objectives and constraints. Regardless of the amount of risk one is willing to assume, modern portfolio theory stresses thorough diversification into different asset classes with correlations that are not perfect (i.e., they are less than 1). By doing so investors can find a way to achieve a goal return with the least amount of risk assumed or, conversely, find a way to maximize return for a given level of assumed risk.

If asset classes are so critical to portfolio design, that brings up a key question, “What exactly is an asset class?” At the core, an asset class is a group of securities that exhibit similar characteristics and behave similarly. The three main characteristics typically used to define an asset class are its expected return, expected standard deviation, and its expected correlation with other asset ...