Asset classes are the building blocks of your investment portfolio. Learn more about the seven most important asset classes in this beginner-friendly guide.
One of the most common investment strategies is to diversify your portfolio in different asset classes. Asset classes include investments with specific characteristics in common and may behave similarly under the same conditions.
This post will cover the different types of asset classes, explain how they work, and which one you should invest in.
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.
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.
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:
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.
Financial experts have yet to agree on a standardized categorization of asset classes. However, 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 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 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. However, this is unlikely given the current low-interest rates.
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:
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. You can regulate the risk by choosing between stable companies that offer more stability in return for less growth or risky companies with higher growth potential but a worse track record.
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.
Fixed-income securities are assets that pay 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 security. 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:
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.
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.
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:
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.
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:
Commodities are directly linked to the rate of inflation. The inflation rate is the rate at which goods services become more or less expensive. A rising inflation rate means that your purchasing power decreases. The link between commodities and the inflation rate comes from using commodities as central building blocks of other products.
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 relative to inflation.
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:
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.
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).
The most common types of currencies are:
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 previously mentioned asset classes vary a lot in their risk level. Therefore, you should make sure that you understand the expected risk and possible reward of each asset class. 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.
Inflation is the rate at which goods and services become more expensive. It causes your purchasing power to decrease. Therefore, your investments must outpace inflation to retain or increase the value of your assets.
The value of different asset classes is affected differently by inflation. Real Estate and commodities tend to rise during inflation. Equities and derivatives may also outpace inflation, but in their case, it highly depends on each individual investment. Cash and cash equivalents, currencies, and fixed-income securities often decrease in value during inflation as their value is directly linked to the purchasing power or because they have a fixed value.
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:
For beginner investors, cash and cash equivalents, equities, and bonds are probably the asset classes that are the easiest to understand. While real estate would also be a possible fit, you will most likely not have the required capital yet to invest in it.
Your first priority should be to start saving. Next, you can look into equities, especially exchange-traded funds, stocks. Once you feel comfortable with investing in equities you can look into further asset classes.
Continue with the next lesson of our beginner-friendly guide “Basics Of Investing”.