Asset classes are investment categories with similar characteristics governed by the same rules and regulations. Traditionally, there are three main asset classes: equities, bonds, and cash equivalents. In recent years, investors have added two more: alternative investments, such as real estate and cryptocurrencies, and commodities.
Having a diversified portfolio is essential to successful investing. Different asset classes have varying risk profiles and investment returns. By thoughtfully investing in each one, you manage investment risks and increase your earning potential. Of course, you must consider your short-term and long-term financial goals when deciding which asset class to invest in.
A clear financial goal matched to a suitable asset class is essential to becoming a savvy investor.
What are the Top 5 Asset Classes
These are the five major asset classes:
1. Equities (stocks)
2. Fixed Income Securities (bonds)
3. Cash and Cash Equivalents
5. Alternative Investments (real estate, etc.)
Equity Asset Class
One of the most popular forms of investment, equities—also called stocks—are ownership shares of a publicly-owned company. They are purchased from a stock market, and their value increases with the company's value over time.
Two ways to earn from equities are through dividends or stock trading. Investors typically receive quarterly dividends depending on the company’s profitability. They can also opt to sell their shares for a higher price to produce a profit.
Equities are considered high-risk asset classes that yield some of the highest investment returns. They are highly volatile, which deters new and unfamiliar investors from considering them. However, there are ways to safely invest in equities without exposing yourself to too much risk. You can invest indirectly in individual stocks or you can invest indirectly with investing in mutual funds and exchange-traded funds (ETFs). The indirect method has the advantage that with less money you have a well diversified portfolio.
Another way to minimize risks when investing in equities is by hiring a third-party to help navigate the uncertainties and create a solid risk-reward portfolio.
Fixed Income Security Asset Class
Fixed income securities are financial instruments that provide investors with a regular income stream. The most common fixed-income securities are bonds, which governments and corporations issue to raise capital. Bonds typically have a term of 10 or more years and make interest payments semi-annually or annually.
Fixed income securities are often seen as more stable investments than stocks because they provide a predictable income stream and investors get their capital first in case of the issuer’s bankruptcy. In contrast, during bankruptcy, stockholders only get what’s left after all bond investors are paid. However, they also tend to have lower returns than stocks, so it is essential to carefully consider your investment strategy before deciding whether to invest in fixed-income securities. To achieve the maximum return when investing in bonds and other fixed-income securities, investors must wait until the maturity date. Bonds can also be sold in secondary markets but their value is affected by interest rates. Bond values increase when interest rates decrease and bond values decrease when interest rates increase. Investors can sell bonds at any time but realize a loss to face value if during the holding time interest rates increased.
Cash and Cash Equivalents
Cash asset classes are typically composed of cash, cash equivalents, and short-term deposits. The common characteristic of this asset class is liquidity. Investors can quickly convert these assets to currency for any purpose. This is important if you need to reallocate your funds to other investment opportunities rapidly or if you anticipate any large financial purchases ahead. Since they are highly liquid, cash assets have the least returns among the different asset classes. In fact, in some cases, inflation rates may beat their return rates.
Examples of cash assets include treasury bills, short-term government bonds, and commercial papers. These are debt instruments that mature in one year or less. While it’s true that cash is king, it’s not advisable to invest mainly in cash assets. Invest only a small portion in this asset class when diversifying your portfolio. Ideally, it should only be enough for any short-term financial plans.
Commodities Asset Class
Commodities are physical products, such as agricultural produce or natural resources, that are bought and traded in bulk to produce other goods and services. Because of their bulk nature, businesses are the usual investors who use this asset class.
There are several ways to add commodities to your investment portfolio. The most common one is by using futures, an investment instrument that determines the future date when the goods will be available and sets the price for them.
Another way that even individual investors can use are commodities pools like ETPs (exchange-traded products) and specifically designed mutual funds. In these situations, you don’t own a share of the asset and are only trading the rights to buy and sell the assets within a short period.
This investment is very risky, and newbie investors are advised to consider other asset classes. Also, without sufficient knowledge of the market prices of commodities, it will be hard to invest in this asset class.
Alternative Investment Asset Class
Aside from the ones described above, there are many other asset classes such as real estate, commodities, and cryptocurrencies. These are classified as alternative investment assets since they are not part of the traditional types of investments.
A real estate investment asset refers to purchasing properties such as buildings, property lots, commercial real estate, or rental homes meant to generate profits through leasing or reselling at a higher market value, such as flipped houses. Real estate investments generally produce high gains but also carry high risks, such as the devaluation of the real estate market. To become a savvy real estate investor, you must conduct due diligence and understand the current market.
Collectibles are another example of alternative investment assets. These assets retain their value over time and are highly marketable. Collectibles can be art or jewelry, and investors usually purchase them directly.
A trending alternative investment today is cryptocurrencies. These are digital currencies like Bitcoin, whose transactions are governed by blockchain technology. They are seen as an alternative form of finance to traditional fiat currencies. There are thousands of cryptocurrencies, and choosing one to invest in can be intimidating. However, the crypto market is highly volatile, and some traditional investors remain skeptical of its sustainability. But seeing famous figures like Elon Musk invest in cryptocurrencies convinces most to consider these as an alternative investment.
Different Investment Approaches
Just as there are different asset classes, there are also different investment strategies catering to an investor’s financial situation and goals. Forming an investment strategy before investing in any asset class is important to minimize risks and maximize returns. An investment strategy must be based on an investor’s risk profile, financial knowledge, and investment goals.
Active Investing vs. Passive Investing
Active investing involves frequent trading of an asset class to earn the maximum profit possible. It’s commonly applied with stocks by watching the stock market and buying when the price is low and selling when the price is high. This investment strategy often requires technical analysis, which involves understanding market movements. Timing is crucial because investors need to beat the market.
Active investing is ideal for younger investors who can make riskier investments as they take advantage of volatile market conditions. It’s also ideal for investors who can spend time and resources watching and analyzing the market to know when to make the right move.
You can also delegate the active investing to a portfolio or fund manager that you trust.
In contrast, passive investing is for more risk-averse investors who are investing for the long run. Passive investors don’t have the time to track the market and instead create portfolios based on a market index. They are comfortable holding their shares for extended periods to give a market index sufficient time to balance the volatility characteristic in short-term trading. Returns and transaction costs are lower compared to active investing. Investors who follow that approach often buy ETFs.
Growth Investing vs. Value Investing
Growth investing focuses on companies with solid prospects for future expansion. These companies are growing rapidly and are expected to continue doing so. Because growth stocks tend to be more expensive than other types of stocks, growth investors must be willing to pay a premium for their shares. This can lead to higher risks and greater potential rewards.
Growth investing is ideal for investors who understand trends and confidently predict company performance. It requires a higher tolerance for risk, as investors are betting on companies that may not have a proven track record. Growth stocks also tend to be more volatile than other types of investments.
On the other hand, value investors focus on finding companies that are undervalued by the market. They look for companies with solid fundamentals that trade at a discount to their intrinsic value. Value investors often take a more patient approach, as they may need to wait for the market to catch up to the stocks’ true value. However, this patience can pay off with above-average returns over time.
Value investing is often seen as a more conservative approach, as investors typically invest in established companies with a history of profitability. However, value stocks can also be volatile, and there is no guarantee that they will eventually reach their full potential. Value investors are patient investors looking for long-term gains and willing to hold onto their stocks even when the market is going through a down period.
Different Investment Instruments
In the past, investment instruments were limited to stocks and bonds. Today, more investment instruments are available to every investor seeking to diversify their portfolio. Investment instruments—also called financial instruments—are contracts that give rise to financial assets.
Financial assets are any contractual right to receive cash or another financial asset from another party. Financial instruments can take many different forms, but they all fall into one of two broad categories: debt instruments and equity instruments.
Debt instruments include bonds and loans, while equity instruments include stocks and options. Each type of financial instrument has its own unique characteristics, but all of them can be traded on financial markets. Financial instruments are an important part of the global economy and play a vital role in facilitating the flow of capital between investors and businesses.
Stocks are equity instruments that represent ownership in a company and offer the highest investment returns. It also carries the highest investment risk since stocks are subject to market volatility. However, a diversified portfolio should contain enough stock allocations corresponding to the investor’s age. As one ages, financial advisors recommend allocating fewer funds to stocks.
A bond is a debt investment in which an investor loans money to an entity (typically corporate or governmental) that borrows the funds for a defined period at a variable or fixed interest rate. Investors purchase bonds for additional cash since interest payments are made periodically, providing a predictable income stream. This is advisable for investors looking for steady income streams during retirement.
Bonds are low-risk instruments because they tend to be more stable and predictable. However, they do carry some risks. The most common risk associated with bonds is interest rate risk. If interest rates rise, bond prices fall; if interest rates fall, bond prices rise. In addition, there is credit risk, which is the risk that the issuer will fail to make interest or principal payments.
Mutual funds are a type of investment instrument that allows small investors to pool their money together and benefit from the expertise of a professional fund manager. The fund manager then invests the money in a diversified portfolio of assets, including stocks, bonds, and other securities. One of the main advantages of mutual funds is that they offer diversification. By investing in a fund, investors gain exposure to a wide range of assets, which can help mitigate risk.
Additionally, mutual funds offer liquidity, which is the ability to convert the asset back into cash quickly and at a fair price. This is an important consideration for investors who may need to access their money unexpectedly. Mutual funds are also great investment instruments for long-term financial goals such as a house purchase or retirement.
Exchange-Traded Funds (ETFs)
Exchange-traded funds (ETFs) are investment vehicles that hold several assets, such as stocks, bonds, or commodities. They are traded on exchanges like stocks, offering investors exposure to a wide range of different asset classes to help diversify their portfolios. ETFs tend to be more affordable than traditional mutual funds since they have lower expense ratios and offer greater flexibility since they can be bought and sold throughout the day. For these reasons, ETFs are becoming increasingly popular as investment instruments.
Real Estate Investment Trusts (REITs)
Real Estate Investment Trusts (REITs) are an alternative method of investing in profitable real estate properties such as commercial complexes, vacation rentals, hotels, etc. They work like mutual funds that provide regular dividend payments. They are highly liquid, unlike their physical counterparts, and are a great way to add a high-earning investment instrument to your portfolio.
Futures refer to contractual agreements to buy or sell an underlying asset at a future date. An exchange standardizes futures contracts to ensure contract predictability and market liquidity. The terms of the contract—including the price of the underlying asset—are set at the time of purchase.
Futures can be used in both short-term and long-term investing strategies. Some investors use futures to take advantage of short-term price changes in the underlying asset, while others may hold a position for months or even years.
The most common type of futures contracts are commodities, such as agricultural products, precious metals, and energy. However, futures contracts are also used for financial instruments like bonds, currencies, and stock indexes.
Futures provide investors with a way to protect their investments against price risk or speculate on price movements in the underlying asset. It’s also a way to gain exposure to price movements in some of the world's most popular markets. Depending on your investment strategy, they can be good investment options. Since the contracts are standardized, they are relatively easy to trade. In addition, since the price is set at the time of purchase, there is no need to worry about timing the market. However, if the underlying asset’s price moves opposite to what was expected, there is the potential for loss.
Structured products are investment instruments that combine features of both traditional investments, such as stocks and bonds, and derivatives. Because of this hybrid structure, investors can enjoy several benefits, including higher potential returns, lower risk, and greater flexibility. For example, a common type of structured product is a reverse convertible bond, which pays periodic interest payments like a bond but also allows the investor to participate in the upside potential of the underlying stock.
This can be especially beneficial in periods of market volatility, when traditional investments may underperform. In addition, structured products can be customized to suit the specific needs of investors, making them an attractive option for risk-averse investors looking for ways to protect and grow their wealth.
Making the Right Investments
When it comes to investing, there are different asset classes to choose from. Each asset class has its own set of risks and rewards. As such, it is important to consider your options carefully before making any decisions. Ultimately, the best entry point for an investment will depend on your investment strategy.
Another thing to consider is the amount of risk you are willing to take. Every form of investment carries its own risks. High-return investments involve high risks, while low-risk investments involve lower returns. Consider also the issue of counterparty risk, which is the possibility that the stock or bond issuer goes bankrupt. However, there are many ways to mitigate these risks, such as investing in funds and ETFs, which are not affected by any company’s bankruptcy.
Investing may seem like an intimidating process, but it shouldn’t be. With a trusted advisor, you can make the right investment decisions that align with your personal goals and needs.
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