An asset class is a group of securities that react with similar behavior to economic forces and activity.
Different asset classes generally don’t correlate with each other, and oftentimes, there is even a negative correlation between asset classes. But many asset classes fluctuate with the change of economic forces. Bond prices for example, are heavily sensitive to interest rates, which are set by the central banks. Stocks as a whole tend to go up when interest rates are low, as investors become more confident about future expectations.
All asset classes have their up and downtimes depending on economic circumstances, and many other factors. It is hard to determine the perfect asset class for the current economic situation. This is why many investors prefer to spread out their investments in several different asset classes to reduce the overall risk of suffering a significant loss in their portfolio.
There isn’t any official definition of how many asset classes really exist but many economists would agree on four main asset classes.
Stocks or Equities
Companies issue shares of stock publicly with the intention of raising money in order to fund business further growth. As a result, investors become able to buy shares of those businesses at stock exchanges, turning them into shareholders of the company.
Shareholders can profit through capital appreciation, which is the increase in the share price of the stock. They may additionally have the right of receiving dividends if the company intends to pay dividends. However, some businesses prefer to fully reinvest their earnings back into the company. Shareholders should then optimally benefit from those reinvestments in the long run.
Investing in the stock market is well-known for its high return compared to other asset classes, although individual stocks can perform quite differently from the average market’s performance. For instance, penny stocks usually fluctuate much more than blue-chip stocks and major companies such as Coca-Cola Co. or Apple. That being said, the average annual return of stocks over the past 20 years is considered at around 8%.
Bonds or similar fixed instruments
Fixed income investments are securities that pay the investor interest on a fixed schedule. The payments continue until the maturity date, where the whole amount of the initial investment, also called principal is being repaid.
Bonds which are basically loans from governments and companies are generally considered less risky than many other asset classes. However, there isn’t a lot of return expected when compared to stocks or real estate.
As a bond investor, you can either make money by holding bonds until their maturity date and collecting their interest payments or by selling bonds at a higher price than what you initially bought them for.
Cash and cash equivalents
Cash and cash equivalents is all money that can be held in form of cash or cash equivalents such as bank accounts, commercial paper, or short-term bonds. Cash basically doesn’t make any return but it does serve the purpose of holding money, which can be easily accessed at any given time.
Many investors prefer to have a percentage of their investment portfolio in cash. It’s hard to predict when bad times are likely to occur and having cash for additional diversification purposes can potentially smooth out severe losses and provide access for further investments whenever opportunities arise.
Tangible Assets such as Real Estate
Tangible assets are all items that have a physical form, and typically a clear value in the marketplace. They include for example, land, equipment, property or real estate. Tangible assets are the opposite of intangible assets, which are non-physical assets such as patents, trademarks, or goodwill.
Many investors consider tangible assets as a form of hedge against economic uncertainty. History shows that most tangible assets like, for example, gold can be held as a protection against high inflation.
There are many ways to invest in real estate. You could directly buy a rental property and rent it out, or invest in Real Estate Investment Trusts. The average annual return of investing in the real estate sector varies from time to time but has been around 10% over recent decades, making them one of the best performing asset classes to invest in.
Why Diversification Is Important
Each asset class has different levels of risk. Investing in equities is generally riskier than investing in bonds but can usually provide a higher return for investors. The easiest and most impactful way to reduce the risk of facing a severe loss is to diversify your investment portfolio.
The purpose of diversification is to reduce your exposure to overall market risk and maximize your return in the long run. This can simply be done by allocating your capital amongst several different asset classes.
If your portfolio consists of only one asset class such as equities, you are entirely exposed to certain types of risk and your portfolio is likely going to experience a noticeable drop in value as soon as the stock market crashes. At the same time, other asset classes might behave in a completely different way to the same economic event.
However, when you spread out your investments evenly, and one asset class underperforms, you still have the other asset classes that might perform positively and help you smooth out severe losses.
Even if you are undoubtedly confident about your chosen stocks, it is only logical to prepare yourself from the worst case. You should use the characteristics of different asset classes as your advantage because whenever a severe decline occurs, it is doubtful that assets like stocks, bonds, and silver would decline at the same time.
How you diversify your portfolio and in what asset classes you want to be more invested in is completely up to you and your risk tolerance. In general, if you want to get higher returns, you might have to accept more risk. Of course, that isn’t always the case, as smart investors can still find low-risk investments with high returns. That being said, this can be very hard and time-consuming.
One factor that determines your risk tolerance is your investment time frame. Older people will less likely want to be heavily exposed to stocks because chances are they won’t be able to fully recover from market crashes and severe portfolio declines. Instead, they should rather have a big proportion of their investments in bonds, or other lower-risk assets.
If you think that you have a high-risk tolerance and still have the time frame to bear out any severe losses over the long term, then it makes more sense to be more invested in high-return assets like equities or real estate.
There are several different asset classes within the marketplace, and each asset class has its own characteristics and behavior to economic events. Each asset class also comes with separate returns and risks for investors.
Even if equities might look very attractive to many investors, most people shouldn’t be completely immersed into stocks, because the stock market only does well in bull markets and a sudden stock market decline along with an economic downturn can turn out bad for investors who do not commit themselves to a well-diversified portfolio.