The 7 Most Essential Asset Classes Explained
Asset classes are the building blocks of your investment portfolio. In this chapter, we will explore the seven most important asset classes.
In this chapter, we’ll take a look at:
Once you understand what investing is and how it works, you should learn about the different types of assets you can invest in. These types of assets are called asset classes and include investments with similar characteristics and risk profiles. A common investment strategy is to diversify your investment portfolio to hold different asset classes and reduce your overall risk.
🧭 Key Takeaways
- Asset classes are the main building blocks to create a diversified portfolio and reduce your overall investment risk.
- They are broad categories that include assets with similar characteristics and risk levels.
- The most common asset classes are cash and cash equivalents, equity, fixed-income securities, and real estate. However, there are also more advanced asset classes.
- As a young beginner investor, you should first focus on cash and cash equivalents, equity, and fixed-income securities.
What Are Asset Classes?
Many asset types share similar characteristics with other types of investments. These characteristics may include how you make money, its risk and reward profile, and the laws and regulations that apply to the asset.
As a result, similar types of investments are commonly grouped into broad categories. These categories are frequently referred to as asset classes.
Why Are Asset Classes Useful?
By investing in different asset classes, you can diversify your investment portfolio and reduce the overall investment risk.
There are multiple reasons why asset classes can help you to set up a diversified portfolio:
- When you invest in assets of a specific asset class, you can expect these investments to behave similarly.
- Usually, there is very little, sometimes even a negative correlation between asset classes. Therefore, if one asset class has negative results, other asset classes in your portfolio can balance them out.
- As different asset classes have different risk profiles, you can balance out risk between asset classes.
- Different asset classes are expected to perform differently in any market environment.
As you can see, the main benefit of asset classes is that their different characteristics help to balance out the upsides and downsides of other asset classes in your portfolio.
What Types Of Asset Classes Should I Know?
Financial experts have yet to agree on a standardized categorization of asset classes. Some prefer to use fewer and broader asset classes, while others prefer more specific ones.
However, the most common types of asset classes to invest in are:
- Cash and cash equivalents
- Equity
- Fixed-income securities
- Real estate
- Commodities
- Derivatives
- Currencies
Cash And Cash Equivalents
Cash and cash equivalents are very safe investments as their value doesn't fluctuate a lot and is relatively stable over time. Cash means physical money, while cash equivalents refer to assets that are similar to cash and have similar characteristics. These may include high-yield bank and savings accounts, money market funds, or certificates of deposit.
While cash and cash equivalents are very safe investments, there are multiple disadvantages of investing in them. First, high safety means that you will only achieve small returns on your investment. Depending on the current interest rates, you might not make any return at all.
Second, the value is subject to inflation and therefore decreases as inflation increases. Ideally, your investment return should at least outpace the current inflation rate.
👍 Benefits
- Cash and cash equivalents are highly liquid and can be used at any time.
- The risk of owning cash and cash equivalents is very low.
- Banks typically pay you a safe and stable interest rate if you hold cash or cash equivalents.
👎 Drawbacks
- The returns are often low and may not outpace the current inflation rate.
- You may have to pay a penalty if you want to access some cash equivalents, like certificates of deposits, prematurely.
Equities
When you invest in equities, you will trade your money in return for ownership in a company or investment fund. You can buy and sell most equities on public market exchanges. However, some equities, like private equity or hedge funds, are only accessible to institutional investors, accredited investors, and high net worth individuals.
The most common types of equities are:
- Stocks
- Preferred stocks
- Exchange-traded funds
- Index funds
- Mutual funds
- Hedge funds
- Private equity
Contrary to cash and cash equivalents, investing in equity has a higher risk but also offers a much higher return. In addition, the level of risk is much more dependent on the individual investment itself. For example, you can control the risk by choosing between stocks of stable companies that offer more stability in return for less growth or stocks of risky companies with higher growth potential but a worse track record.
💡 Example
The return you can receive on a savings account will be very similar between different banks. In contrast, the return on a stock is highly dependent on the company's current state and future expected earnings.
For example, the demand for a product might fall, leading to lower expected earnings in the future. As an equity investor, you will be rewarded with a higher return for accepting this uncertainty in the future value of your investment.
👍 Benefits
- Publicly traded equities are easy to buy and sell.
- Some equities, like stocks or exchange-traded funds, are highly liquid and easy to sell quickly.
- It is possible to reduce your risk by diversifying across different industries and market sectors.
- You can earn money both from an increase in the value of your equities and from dividend payments.
👎 Drawbacks
- The value of your equities may change any time and returns are not guaranteed.
- Equities tend to be more volatile than other asset classes.
Fixed-Income Securities
Fixed-income securities are assets that promise to pay you fixed income over a set period of time. They typically include various forms of bonds, notes, and debentures, with bonds being one of the most popular fixed-income securities. Most fixed-income securities are being issued by the government or companies to raise new money.
The most common types of fixed-income securities are:
- Bonds
- Debentures
- Notes
- Private debt
- Distressed debt
When you invest in fixed-income securities, you will earn a regular income in the form of interest payments. However, contrary to cash and cash equivalents, you will be able to receive a higher interest by purchasing fixed-income securities with a higher risk and vice versa. Therefore, you have more control over balancing out risk and reward than you have with a regular savings account.
💡 Example
You could purchase bonds of established companies with a low risk of bankruptcy. As these companies have a stable track record of paying their debt, you will receive a lower interest as you don't take on as much risk. Contrary, when you purchase bonds of a company close to bankruptcy, you will receive a higher interest in return for taking a higher risk of losing the value of your investment.
👍 Benefits
- Fixed-income securities pay you a fixed return on your investment.
- Most fixed-income securities are less volatile than other asset classes, like equities.
- Credit rating agencies are rating and evaluating most fixed-income securities.
👎 Drawbacks
- Fixed-income securities are typically not very liquid and easy to sell.
- Bond prices are coupled to interest rates. Therefore a rise in interest rates will lead to a decline in bond prices.
- The prices of fixed-income securities are also impacted by the impact of inflation.
Real Estate
Real estate is the most popular and one of the largest asset classes to invest in. This asset class includes real properties that are based upon the land. They include any improvements that have been made on top of this land. These include man-made improvements, like buildings or infrastructure, or natural improvements, like planting trees.
The most common types of real estate are:
- Residential real estate
- Commercial real estate
- Land
There are two ways to make money with real estate. First, you can receive a regular monthly income in the form of rental income. Second, you can increase the value of your property and sell it at a higher price than you bought it.
Unlike other investments, which only serve the purpose of making money, you can also purchase real estate and use it for yourself instead of renting out real estate.
👍 Benefits
- Real estate can offer high returns on your investment.
- You can receive regular income if you rent out your property.
👎 Drawbacks
- Real estate requires a high upfront investment or the use of leverage.
- It may take some time to grow the value of your real estate.
- Real estate is less liquid than most other asset classes and it can take lots of time to sell your property.
- A vancancy can interrupt your cash flow that you receive from rental income.
Commodities
Commodities are one of the oldest asset classes in existence. They are raw materials, often natural resources, that can be grown, extracted, or harvested. These raw materials can then be used as building blocks to manufacture other goods.
The most common types of commodities are:
- Energy sources, like oil and gas
- Metals like silver, gold, or aluminium
- Wood
- Livestock
- Agricultural products
Because they are the basic building blocks of many products, commodities are directly linked to the rate of inflation. When you trade commodities, you're betting on rising prices of commodities. However, commodities are also popular investments during economic downturns as they tend to maintain their value quite well relative to inflation.
👍 Benefits
- Most commodities are highly liquid and easy to sell.
- Commodities can help to diversify your portfolio and balance your overall risk.
- Commodities can protect your portfolio agains the impact of inflation.
👎 Drawbacks
- Commodities tend to have volatile prices.
- As commodities are physical products, you have to store them somewhere.
Derivatives
Derivatives are complex financial contracts that derive their value from an underlying asset. Common underlying assets include stocks, bonds, commodities, or currencies.
There are two major variants of derivatives. First, so-called “lock” derivatives bind you to the agreed-upon terms over the life of the contract. On the other hand, “option” derivatives give you the right, but not the obligation, to buy or sell the underlying asset at a specified price before the contract expires.
The most common types of derivatives are:
- Options
- Futures
- Swaps
Derivatives are highly complex financial products and are not suitable for beginner investors. While you can earn high returns with them, their complexity also exposes you to an increased risk of losing your money.
👍 Benefits
- Most derivatives are highly liquid and can be sold easily.
- Derivatives are well regulated.
👎 Drawbacks
- The use of leverage can increase your overall investment risk.
- Most brokers will require you to make a minimum deposit.
Currencies
Currencies are often overlooked as their own asset class. However, the currency market, also known as Forex market, FX market, or foreign exchange, is the largest and most liquid market globally. The market determines the exchange rate between two currencies, such as between the Euro (EUR) and US Dollars (USD).
When you trade currencies, you buy a pair of currencies, for example, between Euro and the US Dollar. However, instead of earning a profit through price appreciation, you earn money if the exchange rate moves in a favorable direction. When it does, you can make a profit by converting your cash back at a better exchange rate.
The most common types of currencies are:
- Fiat currencies
- Cryptocurrencies
👍 Benefits
- Currencies are highly liquid and can be easily sold.
- There are no trading hours for currencies and you can buy and sell them 24 hours a day.
- Investing in currencies usually is quite cheap.
👎 Drawbacks
- Currencies can be quite volatile.
- The use of leverage can increase your overall investment risk.
- Currencies don't have any underlying value or cash flow. Therefore, their value is purely based on supply and demand.
What Is The Risk For Different Types Of Asset Classes?
Asset classes vary a lot in their risk levels. While cash and cash equivalents and fixed-income securities are probably the least risky asset classes, they also offer the lowest returns. On the other hand, real estate and equities provide higher returns but also have a higher risk. Therefore, you should ensure that you understand each asset class's expected risk and possible reward. Ideally, you should only invest in asset classes that match your risk tolerance.
The following graph indicates the different risk and reward ratios of different types of asset classes:
What Asset Classes Should Beginner Investors Start With?
Now that you understand the basics of each asset class, you may wonder which asset classes you should invest in. You should consider these factors when picking asset classes for your investment portfolio:
- Do you understand the characteristics of the asset class?
- Does the risk and reward ratio of the asset class match your risk tolerance?
- What impact does the asset class have on other investments in your portfolio?
For beginner investors, cash and cash equivalents, equities, and bonds are probably the asset classes that are the easiest to understand. Ideally, you should start with exchange-traded funds, and stocks. Once you feel comfortable with investing in equities you can look into further asset classes, such as real estate, or bonds.
Next Chapter
Continue with the next lesson of our beginner-friendly guide “Basics Of Investing”.