Asset classes are the building blocks of your investment portfolio. In this chapter, we will explore the seven most important asset classes.
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.
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. 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 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.
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. 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.
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 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:
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 are:
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:
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.
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).
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:
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:
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. 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.
Continue with the next lesson of our beginner-friendly guide “Basics Of Investing”.