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Asset classes explained: definition, types and examples
Understanding how different asset classes perform in isolation and relative to each other is a linchpin of successful long-term investment.
QUOTE
“It is not prudent to attempt to switch and swap asset classes based on short-term market predictions.”
The main asset classes you need to be aware of are stocks (equity) and fixed income (bonds), followed by cash and its equivalents.
Others derive their value from stocks and bonds like ETFs and mutual funds. Meanwhile, Foreign Exchange (FX), futures, and options are more relevant to trading than investing.
Others derive their value from stocks and bonds like ETFs and mutual funds. Meanwhile, Foreign Exchange (FX), futures, and options are more relevant to trading than investing.
Big ideas
- The major asset classes are equities, fixed income, and cash and its equivalents.
- Asset allocation is a vital part of diversification and long-term profitability.
- You should not change your mix of asset class allocation too frequently.
What are asset classes?
An asset class is a group of investments with similar features. Stocks, for example, behave similarly to each other, whereas bonds behave differently to stocks and are a separate class unto their own.
Within them, there are many subdivisions of asset classes. You can have safe stocks or volatile stocks. You can have US or emerging market stocks, large cap or small cap stocks. You can have investment-grade bonds and junk bonds.
Within them, there are many subdivisions of asset classes. You can have safe stocks or volatile stocks. You can have US or emerging market stocks, large cap or small cap stocks. You can have investment-grade bonds and junk bonds.
The asset classes in more detail
The most common asset types individual investors are likely to deal with are:
- Stocks (shares or equity)
- Fixed income (bonds)
- Cash & cash equivalents
- Commodities
- Funds
- Derivatives
- Alternatives (incl. forex & property)
1. Stocks
Stocks, also called shares or equities, are the most common and essential component of a portfolio. A stock is simply a share of a company. So when you own a stock, you own a piece of a company. Some stocks pay dividends to shareholders, providing an additional form of income.
Stocks have the ability to generate higher returns than other asset classes, depending on how well the company does. You can analyse the company's financials to see whether a stock is overvalued or undervalued.
Stocks can be broadly divided into first world or emerging stocks. First world stocks are mainly those from the UK, US, and Europe. Emerging stocks are from countries that are less affluent. Emerging stocks often have higher risk but higher potential rewards.
There are many other subcategories of stock. There are large cap stocks vs small cap stocks. There are stocks within an industry, such as tech stocks or real estate stocks. There are volatile penny stocks and stable defensive stocks.
The commonality is that you are always investing in a company, so the company had better have strong financials, be in a good market, and have strong leadership.
Stocks have the ability to generate higher returns than other asset classes, depending on how well the company does. You can analyse the company's financials to see whether a stock is overvalued or undervalued.
Stocks can be broadly divided into first world or emerging stocks. First world stocks are mainly those from the UK, US, and Europe. Emerging stocks are from countries that are less affluent. Emerging stocks often have higher risk but higher potential rewards.
There are many other subcategories of stock. There are large cap stocks vs small cap stocks. There are stocks within an industry, such as tech stocks or real estate stocks. There are volatile penny stocks and stable defensive stocks.
The commonality is that you are always investing in a company, so the company had better have strong financials, be in a good market, and have strong leadership.
2. Fixed income: Bonds
Fixed income refers to any kind of income where you receive interest payments of lending money. The most obvious example is the bond, where you are rewarded for lending out your money with a fixed or floating interest rate.
Bonds can be divided into government/state bonds, corporate bonds, Treasury Inflation Protection Bonds (TIPS), and junk bonds. The invested principal is kept safe while generating an additional return.
Bonds can be divided into government/state bonds, corporate bonds, Treasury Inflation Protection Bonds (TIPS), and junk bonds. The invested principal is kept safe while generating an additional return.
- State bonds are the safest, with the lowest rate of return.
- Corporate bonds are less safe but offer better returns than state bonds.
- TIPS are designed specifically to protect against inflation, as measured by the Consumer Price Index (CPI).
- Junk bonds are very risky, though the returns could be the most lucrative.
With a bond, you are essentially loaning out money to a government or corporation. At a specific date, you will then receive your principal back, with a fixed/floating rate of interest. This makes bonds a good complement to stocks, because your money is very safe with fixed income instruments.
It’s also common now to receive floating or variable rates for bonds. You will then receive the variable interest rate along with your principal investment. A bond means that you, the purchaser, are the lender to the company or government, which use it to finance specific projects. You can also resell the bond at a higher price.
It’s also common now to receive floating or variable rates for bonds. You will then receive the variable interest rate along with your principal investment. A bond means that you, the purchaser, are the lender to the company or government, which use it to finance specific projects. You can also resell the bond at a higher price.
3. Cash and cash equivalents
Cash and cash equivalents refer to any highly liquid securities that are redeemable within 90 days or less. This includes the cash you have in your bank account or physical cash in your possession.
Money market mutual funds and treasury bills are also deemed cash equivalents. Certificates of deposit (CDs) are also a cash equivalent product that is liquid and easily redeemable if the maturity date is within 90 days. Even preferred equity shares can be considered a cash equivalent, depending on the redemption date.
Money market mutual funds and treasury bills are also deemed cash equivalents. Certificates of deposit (CDs) are also a cash equivalent product that is liquid and easily redeemable if the maturity date is within 90 days. Even preferred equity shares can be considered a cash equivalent, depending on the redemption date.
Cash vs Cash equivalent
Generally, a relatively small proportion of your portfolio can be in cash and its equivalents as a safety net. The rate of return for money market products is very low. By holding cash, your wealth will get eroded over time by inflation. Sometimes you have to pay monthly fees to store your money in a bank account, a form of negative interest rate.
However, holding a certain amount of cash or highly liquid securities is also an obvious benefit. It’s always useful to have cash at hand because it allows you to easily and quickly access investment opportunities. If a disaster strikes, you can use this liquid security instead of having to liquidate your other holdings, which can come at a large fee.
However, holding a certain amount of cash or highly liquid securities is also an obvious benefit. It’s always useful to have cash at hand because it allows you to easily and quickly access investment opportunities. If a disaster strikes, you can use this liquid security instead of having to liquidate your other holdings, which can come at a large fee.
4. Commodities
Commodities are material goods that are traded between producers. They are the essential items in manufacturing and engineering used to produce goods on a global scale.
Commodities tend to be entirely speculative as compared to other asset classes. But they are regarded as a good hedge against inflation. This is because, in times of inflation, the price of essential goods goes up, including grain, energy, oil, etc. if you own commodities in the form of stocks, you own these commodities.
While there are many subcategories of commodities, the main ones include:
Commodities tend to be entirely speculative as compared to other asset classes. But they are regarded as a good hedge against inflation. This is because, in times of inflation, the price of essential goods goes up, including grain, energy, oil, etc. if you own commodities in the form of stocks, you own these commodities.
While there are many subcategories of commodities, the main ones include:
Commodities can be purchased to speculate on the movement of a given industry indirectly. For instance, if you think the automobile industry will grow, you can invest in aluminium, iron ore, and petroleum, which are used extensively in automobile manufacturing. You can invest in stocks that own commodities.
There are two broad purchasers of commodities. Some businesses purchase essential manufacturing products on the spot market. Then there are derivative traders who try to profit from commodity price movements using futures contracts in the derivative market.
However, the futures market serves a purpose. A car manufacturing facility might want to lock in a low price for petroleum using the futures market in case the price rises dramatically within the next few months. Generally, commodity markets are reserved for experienced investors, business owners involved with the products, and speculative traders.
There are two broad purchasers of commodities. Some businesses purchase essential manufacturing products on the spot market. Then there are derivative traders who try to profit from commodity price movements using futures contracts in the derivative market.
However, the futures market serves a purpose. A car manufacturing facility might want to lock in a low price for petroleum using the futures market in case the price rises dramatically within the next few months. Generally, commodity markets are reserved for experienced investors, business owners involved with the products, and speculative traders.
5. Funds
Funds can be divided into three broad subcategories - exchange-traded funds (ETFs), mutual funds, and hedge funds.
Hedge funds are not very relevant to new investors, often being open only to accredited investors. An accredited investor can trade unregistered securities due to having advanced financial knowledge and sufficient capital protection.
Hedge funds often use aggressive trading strategies and are not subject to the same regulatory scrutiny as other funds. They have a large minimum investment and a lock-in period of at least a year. Hedge funds can invest in various underlying securities and are more of a private investment partnership.
In contrast, mutual funds are more regulated than hedge funds and have lower barriers to entry. A fund manager/investment advisor picks stocks and bonds on behalf of the investors. Mutual funds are benchmarked against indices, unlike hedge funds which aim to deliver absolute returns.
Mutual funds are publicly traded, unlike hedge funds. Mutual funds will have an investing methodology outlined in the prospectus. With mutual funds, investors need to be mindful of the fees, charges, and commissions which affect returns. Most mutual funds invest only in stocks.
The ETF is one of the most popular investment vehicles for retail investors. This is due to the fact that it can be traded like a stock, unlike mutual funds. Plus, ETFs are generally cheaper to invest in and hold many types of underlying assets instead of just one.
This means ETFs are a great choice for diversification with a low entry fee. Investing in individual securities could be a lot more expensive, not to mention difficult. ETFs can track a particular index or sector. You can have a Gold ETF, International Equity ETF, Liquid Debt ETF, etc.
The table below should give you a quick understanding of the difference between hedge funds, mutual funds, and ETFs.
Hedge funds are not very relevant to new investors, often being open only to accredited investors. An accredited investor can trade unregistered securities due to having advanced financial knowledge and sufficient capital protection.
Hedge funds often use aggressive trading strategies and are not subject to the same regulatory scrutiny as other funds. They have a large minimum investment and a lock-in period of at least a year. Hedge funds can invest in various underlying securities and are more of a private investment partnership.
In contrast, mutual funds are more regulated than hedge funds and have lower barriers to entry. A fund manager/investment advisor picks stocks and bonds on behalf of the investors. Mutual funds are benchmarked against indices, unlike hedge funds which aim to deliver absolute returns.
Mutual funds are publicly traded, unlike hedge funds. Mutual funds will have an investing methodology outlined in the prospectus. With mutual funds, investors need to be mindful of the fees, charges, and commissions which affect returns. Most mutual funds invest only in stocks.
The ETF is one of the most popular investment vehicles for retail investors. This is due to the fact that it can be traded like a stock, unlike mutual funds. Plus, ETFs are generally cheaper to invest in and hold many types of underlying assets instead of just one.
This means ETFs are a great choice for diversification with a low entry fee. Investing in individual securities could be a lot more expensive, not to mention difficult. ETFs can track a particular index or sector. You can have a Gold ETF, International Equity ETF, Liquid Debt ETF, etc.
The table below should give you a quick understanding of the difference between hedge funds, mutual funds, and ETFs.
Metric | Hedge Fund | Mutual Fund | ETF |
Return | Absolute | Relative | Relative |
Management | Active | Active | Passive |
Fees | Based On Performance | Percentage Of Total Allocation + Operational Fees | Percentage Of Total Allocation + Operational Fees |
Transparency | Only To Investors | Annual Reports | Daily |
Regulation | Low | High | High |
Liquidy | Low | High | High |
Cost | Varies | High Expense Ratio | Low Expense Ratio |
Investor Type | High Worth | Retail | Retail |
Fractional Shares | No | Sometimes(Depends On Minimum Investment) | Sometimes(Depends On Minimum Investment) |
6. Derivatives
Derivatives products are largely the domain of traders. The most popular derivatives are futures and options. With an option contract, you have the option to buy or sell a given asset at a specific price, within a certain timeframe. With a future contract, you are bound to buy or sell a given asset at a certain price, at a future date.
These are highly risky products because the loss is theoretically unlimited. However, futures and options do have validity for certain businesses looking to lock in prices for specific commodities. It can serve as a hedge against adverse market movements that could otherwise severely damage a given business.
These are highly risky products because the loss is theoretically unlimited. However, futures and options do have validity for certain businesses looking to lock in prices for specific commodities. It can serve as a hedge against adverse market movements that could otherwise severely damage a given business.
7. Alternative asset classes - FX, real estate, physical, cryptocurrency
There are other assets that are quite relevant, though less critical to be aware of. These include:
- Foreign exchange (FX) - like futures and options, these are mostly the domain of trading professionals that speculate on currency price movements. However, it is relevant to international businesses that operate in different jurisdictions, as well as payment providers. You can also hedge against the domestic market by holding cash in different currencies.
- Real estate - this is its own asset class. A highly relevant subcategory of asset classes within real estate is the Real Estate Investment Trust (REIT). This trust allows investment into real estate without having to own or manage a property. Many ETFs and mutual funds will also target real estate. Rental real estate can also produce a significant income, making it lucrative for potential investors.
- Physical assets - The ownership of valuable physical items is its own asset class. The main one here would be real estate, and there is something of an overlap. But you might also own land, property, or machinery.
- Cryptocurrencies - Despite much initial resistance, cryptocurrencies have finally gained recognition as a distinct asset class. Cryptocurrency tokens are notoriously volatile and are not regulated. But the returns can be extremely lucrative. Investing in early-stage cryptocurrency startups can also be quite profitable, though that would be done in the form of equity as opposed to direct crypto or NFT ownership.
Risk tolerance and asset allocation
The rationale behind understanding the different types of asset allocations all boils down to risk tolerance and investor preferences. Regardless of the asset, the question is, what is the reward and the potential risk?
Younger investors can allocate more of their portfolio towards equity as opposed to fixed income, perhaps in the proportion of 80/20. This is because they have more time to earn an income and more time for savings to grow and compound. Older investors are often advised to proportion their holdings 70/30 fixed income to equity to preserve existing wealth.
Younger investors can allocate more of their portfolio towards equity as opposed to fixed income, perhaps in the proportion of 80/20. This is because they have more time to earn an income and more time for savings to grow and compound. Older investors are often advised to proportion their holdings 70/30 fixed income to equity to preserve existing wealth.
QUOTE
“An investment business has certain risks, and your job as an investor is not to eliminate all risks but to manage and minimize them.”
So, you have to ask yourself how much risk you are willing to take on and what kind of assets you are particularly interested in. The safest approach is a mix of stocks and bonds in some format, and it does not have to be overly complicated once you diversify your holdings and invest steadily over time.
Derivatives, commodities, cryptocurrencies, and FX are generally for advanced traders and investors who have deep market insights. No matter how advanced, it is generally not wise to invest more than 5% of your overall portfolio in a given security due to volatility and the fact that nobody can predict the market. But everybody can diversify and hedge against it.
Derivatives, commodities, cryptocurrencies, and FX are generally for advanced traders and investors who have deep market insights. No matter how advanced, it is generally not wise to invest more than 5% of your overall portfolio in a given security due to volatility and the fact that nobody can predict the market. But everybody can diversify and hedge against it.
Portfolio returns per asset class allocation
Source: Motley Fool via Vanguard. Past performance doesn’t guarantee future resultsThe image above shows the portfolio returns from 1926 to 2021 based on various asset allocations. As can be observed, the 100% stock asset class allocation delivered the best average annual returns and the best-performing year at 54.2%. However, it also delivered the worst year (-43%) and the most years with a loss.
From this data, the takeaway is that any diversified portfolio between stocks and bonds generated 6% to 10% annual returns over longer periods. A portfolio that is not diversified can get wiped out and you might have to sell the portfolio at a sharp loss.
Portfolios can be divided into income portfolios, balanced portfolios, or growth portfolios. Income portfolios have less equity with the bulk of the assets in fixed income, for example (30% / 70%). Balanced portfolios have about equal equity and fixed income (e.g. 50% / 50%). Growth portfolios have more equity than fixed income (e.g. 70% / 20%) or (80% / 20%).
From this data, the takeaway is that any diversified portfolio between stocks and bonds generated 6% to 10% annual returns over longer periods. A portfolio that is not diversified can get wiped out and you might have to sell the portfolio at a sharp loss.
Portfolios can be divided into income portfolios, balanced portfolios, or growth portfolios. Income portfolios have less equity with the bulk of the assets in fixed income, for example (30% / 70%). Balanced portfolios have about equal equity and fixed income (e.g. 50% / 50%). Growth portfolios have more equity than fixed income (e.g. 70% / 20%) or (80% / 20%).
Recap
There are a large variety of asset classes. But the most important ones include stocks, bonds, and cash and its equivalents. Most of the rest are derived from these asset classes or are more niche for advanced traders or industry insiders that operate within the industry or have a passion for it.
You can make a diversified portfolio of stocks and bonds with some cash at hand for emergencies. Portfolios tend to grow with time and diversification as long as no mistakes are made. Time in the markets beats timing the markets.
You can make a diversified portfolio of stocks and bonds with some cash at hand for emergencies. Portfolios tend to grow with time and diversification as long as no mistakes are made. Time in the markets beats timing the markets.
FAQ
Q: What are asset classes?
An asset class is a group of securities with similar features. They behave in the same way and have the same regulatory infrastructure. There are many different types of asset classes, but the most common include stocks, bonds, and cash and its equivalents.
Q: What are the best asset classes to invest in?
This depends on your risk tolerance and investing preferences. The best asset classes are the ones with the biggest reward as compared to the lowest risk. But it's often futile to try and pick out the very best asset classes or securities within a specific asset class. Over the long term, a diversified portfolio with many asset classes will perform very well.
Think in terms of having a diversified and balanced portfolio as opposed to choosing the best asset class. If you are only concerned with high rewards, the best asset class is probably stocks, but it will increase your risk.
Think in terms of having a diversified and balanced portfolio as opposed to choosing the best asset class. If you are only concerned with high rewards, the best asset class is probably stocks, but it will increase your risk.
Q: What are the most common asset classes examples?
The most common asset class examples are stocks (equity or shares), bonds (fixed income) and cash and its equivalents. These are the three major asset classes and have a place in all investment portfolios.
Other asset classes include alternative investments, such as emerging markets and REITs, as well as derivatives and commodities.
Other asset classes include alternative investments, such as emerging markets and REITs, as well as derivatives and commodities.
Q: How do I select asset classes for my portfolio?
You can use an app like Trading212 to build Pies using an AutoInvest feature. You can invest in ETFs as well as fractional shares. You can get a diverse range of stocks through this platform. Cash can also be held in the account, or you can hold cash in your own personal bank account.
Q: Can I access any asset class I want?
Not exactly. Some assets, like hedge funds, are reserved for specific individuals. And not all online brokerages allow access to all asset classes, fixed income and REITs being an example. But you can typically access most publicly traded major stocks, mutual funds, and ETFs through online brokerages.
You can also trade futures and options if you have the experience and capital, but there are some additional requirements for this. Unless you have specific interest or experience, it is best to stick with the major stocks, bonds, and cash equivalents as opposed to the risker and more specialised asset classes.
You can also trade futures and options if you have the experience and capital, but there are some additional requirements for this. Unless you have specific interest or experience, it is best to stick with the major stocks, bonds, and cash equivalents as opposed to the risker and more specialised asset classes.
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