Asset classes are groups of similar investments that may be subject to the same market forces, laws and regulations. For investors, it is important to understand asset classes because each asset class has different levels of risk and return. Thus, investors can build a more balanced portfolio if they use asset allocation to spread their investment across multiple asset classes.
Stocks, bonds and cash are some of the most important asset classes, but some investors opt for a few others to help build a portfolio that is well balanced or less correlated with the broader market.
What is an asset class?
An asset class is a group of similar investments that generally operate on similar principles. For example, many of the largest companies issue stocks, also called shares, which confer certain ownership rights. In contrast, bonds are issued by corporations or governments and are known as fixed income assets and provide certain payments. These asset classes, in addition to cash, form the best-known asset groups.
Types of asset classes
The asset classes below form some of the most important groups for investors to be aware of.
Cash and cash equivalents
Cash is how most people get paid and what we often use to make purchases, so it’s a very liquid asset. These can be US dollars or currencies from another country (or region, in the case of the euro). In contrast, cash equivalents are assets that can be easily converted into cash.
Both types of assets generally have very low risk but low growth potential and are particularly prone to inflation. Examples include money market accounts, savings accounts, and cash itself.
Stocks include shares in companies, which may include publicly traded companies or private companies, and they represent an equity interest in those companies. These assets may have growth potential but may be more volatile than other types of assets. Stock prices can change based on company performance, investor sentiment and economic conditions.
Stocks include both common stock and preferred stock. Buying stocks through a mutual fund or exchange-traded fund (ETF) can allow you to buy a diversified portfolio quickly and easily. Equities have some of the most attractive long-term returns among major asset classes.
Fixed income securities are an asset that investors buy in exchange for interest payments over time. Fixed income assets tend to fall between stocks and cash in terms of risk and growth potential. However, the risk and return potential of fixed income securities tends to be low. The fixed income asset class includes assets such as bonds, annuities and CDs.
Real estate can include many types of real estate, including residential real estate (as a primary residence or investment property), commercial real estate, and real estate investment trusts (REITs). Real estate tends to appreciate slowly over time, and this asset class can perform well in inflationary climates that may be more adverse to other asset classes.
Precious metals can often be a good counter-cyclical investment and include well-known investments such as gold and silver, but also many others. Precious metals can perform well in economic climates that are unfavorable to other asset classes.
Alternative investments are investments that are outside of other more traditional asset classes such as private equity or hedge funds. In some cases, this may be newer assets, such as cryptocurrency (although many well-known investors are strongly resistant to crypto as an asset class).
Part of the appeal of alternative investments is that they can be less correlated to public investments, providing some diversification for investors. But alternative investments can also give investors access to attractive investments that are otherwise off limits to most investors.
Which asset class is the riskiest and which is the safest?
Traditionally, stocks have been considered among the riskiest investments, while cash and cash equivalents have been considered the safest. However, there may be exceptions in both cases. Cash can sometimes be unusually risky, for example when inflation is raging and some stocks are safer than others, although stocks are usually all affected by rising interest rates.
But given the dangers of inflation, cash is not a great investment, while a broadly diversified stock portfolio has helped investors maintain their purchasing power over time.
The fact that we cannot speak in absolutes is precisely why diversification is essential. Spreading your portfolio across multiple assets and asset classes – called asset allocation – will help your portfolio perform better while avoiding some unpleasant surprises. Although you can’t plan for everything, it is possible to build a portfolio that reduces your exposure to unnecessary risk.
How to diversify your portfolio through asset classes
Spreading your investments across multiple asset classes is beneficial as each asset will tend to have a different level of risk and growth potential. Additionally, a diverse collection of assets reduces the correlation between those assets, thereby reducing the volatility of your portfolio. In other words, one asset can perform well while another struggles, and vice versa, reducing fluctuations.
There is no better way to diversify across asset classes, as every investor has different goals and expectations. For example, most financial advisors say younger investors should have a high allocation to equities, while older investors should reduce their equity exposure in favor of lower-risk fixed-income securities. This is because young investors can have many years to weather economic downturns and stock market fluctuations, unlike older investors.
Individual investors also have varying levels of risk tolerance, but portfolios can generally be divided into three broad categories: aggressive, moderate, and conservative. For example, you can diversify your portfolio by using more than stocks and bonds, as follows:
- Aggressive: 80% stocks, 10% bonds, 5% real estate, 5% gold
- Moderate: 70% stocks, 20% bonds, 5% real estate, 5% gold
- Conservative: 60% stocks, 26% bonds, 7% real estate, 7% gold
Some investors might prefer to hold cash rather than gold. So an alternative portfolio might be 82.5% equities, 7.5% REITs and 10% fixed income/cash. There is no limit to the number of ways you can decide to diversify across asset classes, depending on your needs, risk tolerance and time horizon.
But these portfolios illustrate your strategy of diversifying your portfolio with different types of assets and how that might change over time. In general, conservative portfolios reduce their allocation to stocks or other risky assets. They then move that money into more conservative assets, like fixed income assets and cash or cash equivalents.
At the end of the line
Investors need to understand what the asset classes are and how certain types of investments can react similarly to the economic climate. This knowledge can help them build portfolios that are more diversified, less risky and less correlated with the market in general.