Understanding Asset Classes And Their Role In Investment
Melissa Brock5-minute read
June 08, 2023
You may encounter several buzzwords and terms when researching investing, including the “asset classes.” Asset classes are similar, grouped investments.
But what asset class should you invest in, and which asset class fits your situation? The answer is different for everyone, so let’s dive into learning a few investment strategies.
What Is An Asset Class?
An asset class refers to a group of investments with similar features governed by specific rules and laws. Asset classes “behave” similarly to each other. Understanding how asset classes behave can help you mitigate risk and reward in your investment assets.
For example, you may have heard that stocks are riskier than bonds because they don’t offer guaranteed returns like some bonds. Due to the nature of risk and reward, you may want to invest in several asset classes – this is known as diversifying your portfolio. Diversifying your portfolio can help reduce the amount of exposure to one asset in your portfolio, thereby reducing overall portfolio volatility over time.
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Types Of Asset Classes
There are several types of asset classes. Some common asset classes include cash and cash equivalents, fixed income (bonds), real estate, equities (stocks) and alternatives. Let’s look at each asset class and walk through the potential for return and risk for each class investment.
Cash Or Cash Equivalents
Many investors hold cash to maintain liquid assets or provide safety and comfort in volatile times. Liquidity means they are typically available for immediate use. Cash and cash equivalent accounts can include the following:
- Treasury bills: Debt obligations offered by the U.S. Department of the Treasury
- Commercial papers: Debt instruments offered by corporations
- Certificates of deposit (CDs): Savings deposits that hold cash and return interest after a fixed period
- Money market funds: A type of fixed-income mutual fund that invests in short-term debt securities
Cash and cash equivalents, while low-risk and very liquid, typically will not offer you a high return on your financial investment. For example, on deposits under $100,000, the current national annual percentage yield (APY) on 1-month to 60-month CDs ranges from 0.10% to 0.98%, according to the Federal Deposit Insurance Company (FDIC).
Equities Or Stocks
Equities, also called stocks, are a type of investment class. Stocks represent portions of ownership of a company. For example, if you buy one share of a company’s stock, you own one tiny sliver of that company.
Investing in equities means exposing yourself to more risk than investing in cash or fixed income. However, equities have a higher potential to produce more significant returns. Generally, the greater the risk, the more substantial your return may be.
Fixed Income Or Bonds
When corporations or governments want to raise money, they offer bonds, a type of debt security. Borrowers invest in bonds, and the issuers pay back their original investment with interest. For example, a company might issue bonds to investors if it wants to build a new building. The company will promise to pay back the investors’ money plus a stated return. Bonds are like IOUs to investors.
Mortgage-backed securities are similar to bonds. These investment products, which are bundles of home loans and other real estate debt, usually come from Fannie Mae, Freddie Mac and Ginnie Mae, government-sponsored enterprises that buy and securitize mortgages. Those who invest in mortgage-backed securities receive regular payments after purchasing, as long as they hold onto the bond.
Bonds generally have a low chance of garnering high returns, particularly when compared to stocks. You can expect to receive a specific yield at maturity, while a stock could continue to rise for years and have unlimited returns.
Real estate is another popular type of asset class that can break down into two main types of property: commercial and residential property.
Residential property could include investing in single-family homes, condos, townhouses and vacation homes. Commercial real estate could consist of investing in multi-family properties, retail, office space, hotels and other commercial property types. Note that land also makes up another property type.
We can also break property types into several classes, including Class A, B and C. You can choose to invest in the following classes within the real estate sector:
- Class A: Class A properties are the highest quality in the housing market, newer (with few maintenance issues), have great amenities and are typically kept up well.
- Class B: Class B properties might not be as new as Class A properties, not professionally managed and not as well maintained.
- Class C: Class C properties are not usually located in ideal areas and typically have some age on them. They may need renovations to update and usually cost the least amount to rent.
Real estate can add to a diverse portfolio due to the potential for steady cash flow and equity appreciation over time. However, there are risks when investing in real estate, particularly if the housing market turns unpredictable, you choose the wrong location or you experience high tenant vacancy rates.
You can also invest in alternative asset classes, such as cryptocurrency, private equity, hedge funds and more. There are many alternative options, some of which may be incredibly risky. For example, many experts consider cryptocurrency as extremely risky because there is no underlying entity behind it. It derives value only when people “decide” it has value.
Before you choose alternative investments, do your due diligence by investigating all the pros and cons.
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Asset Classes And Diversification
Investing in several asset classes can help diversify your portfolio. Diversification means you spread your investments among several types rather than pouring all your money into a single investment. Putting all your money in a single investment exposes your portfolio to risk. Instead of putting all your eggs in one basket (in, say, a single stock), you’d put a little of it into bonds, a little into real estate and maybe another bit into another asset class.
Diversification helps reduce the amount of exposure to one asset in your portfolio. Make sure you’ve diversified – it's a cornerstone of investing. Mutual funds work like this – they invest in a bundle of stocks instead of a single stock. How an investor diversifies is often based on their age. Younger investors tend to choose more risky investments that could provide higher returns. As investors age, asset classes tend to shift to less risky investments that provide lower returns but with more stability.
Asset Classes FAQs
Let’s look at a few frequently asked questions about asset classes.
Why is it important to consider different asset classes?
Considering different asset classes is important because you want to make the right choices when investing. If you're not sure that you can make the right decisions on your own, consider hiring a local financial advisor to help you manage your money and plan out your long-term goals.
How many asset classes should I have?
There’s no one right answer to this question. If you looked at the portfolios of 100 investors, you’d see 100 different investment strategies. First and foremost, consider whether you’re diversified. Diversification can mitigate risk by spreading out your assets among several categories.
What is the riskiest asset class?
Alternative investments is the riskiest of the four asset classes in this piece. However, equities often present a significant risk to investors because there are no guarantees that you'll make money off the stocks you choose.
Is crypto an asset class?
Some investors consider cryptocurrencies, often called crypto, as a new type of asset class. However, there is some debate about whether it represents a "real" asset class, mainly because it lacks regulatory purview.
The Bottom Line On Asset Classes and Diversification
It’s helpful to group investments into categories that have similar features. Since asset classes act similarly, they can help you achieve your goals. Consider cash and cash equivalents, fixed income (bonds), real estate, equities (stocks) and alternative assets.
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