Understanding Asset Classes
An asset class refers to a group of investment vehicles that can be used to achieve similar financial goals. These investment vehicles are usually regulated in a similar manner. You can expect comparable returns and risks within the same asset class.
Asset class is an important concept, since it helps you gain exposure to different types of investment vehicles. Diversification exists across asset classes but you can also diversify your investments within the same class.
Investment vehicles can be organized into four main classes. It’s important to understand what each class can do for your portfolio, so you can decide on the best asset allocation strategy possible.
Cash equivalents are the safest way to invest your money. The downside is that returns are fairly low compared to other asset classes.
There are some advantages to investing in cash equivalents in spite of the low returns:
- Cash equivalents don’t lose their value if the market takes a turn for the worse. They should represent a significant portion of your portfolio if you’re a conservative investor.
- You can invest in cash equivalents on the short-term. This asset class is ideal if you’re approaching retirement.
- Some cash equivalent products can be borrowed against. This is a good investment if you believe you’ll need to borrow against your portfolio in the future, for instance, to finance a house.
- Returns are usually set in advance. You know exactly what your investment will yield, what the maturity date is, and will not be tempted to take additional risks to potentially earn more.
- Cash equivalents are very liquid. Some products that belong to this asset class give you access to your money at any time.
Savings accounts are a popular investment vehicle that belongs to this asset class. Money market instruments also belong to this class, including certificates of deposits, repurchase agreements, federal funds and U.S. Treasury bills, and commercial papers.
Cash equivalents are best used to keep your money safe and secure, with guaranteed profits, even if the returns are low compared to other investments.
Cash equivalents will not help you grow your portfolio to any great extent, but allocating a percentage of your resources to this type of safe investments will protect you from losses in case other portions of your portfolio don’t perform well.
Fixed income securities are investment vehicles with regular payments. You also get your initial investment back once the product reaches its maturity.
There are a few downsides to investing in fixed income securities:
- These securities are traded between dealers and between dealers and individual investors. There is no central pricing information, which can make it difficult to know if you’re paying a fair price.
- Some securities are very difficult to find. It could be months before you have the opportunity of purchasing the security you were interested in.
- The returns are low. On the plus side, you aren’t taking any significant risks. Plus, you benefit from a predictable income.
Fixed income securities are a great way to protect your portfolio from market fluctuations. You will receive the scheduled payouts regardless of how the market performs and can actually generate a nice profit with this type of securities if you wait for the right products to be available.
Bonds are the most popular fixed income securities. You can purchase bonds from the U.S. government or from foreign governments, but should also consider investing in corporate bonds. This asset class also includes preferred stocks with dividends.
This asset class is a fairly safe way to invest your money. Some securities carry higher risks than others do, but you can easily avoid taking risks by investing in bonds issued by governments and large corporations.
Bonds and other fixed income securities do not require you to actively manage your portfolio and provide you with a reliable source of income. The returns are fairly low, but these investment vehicles are still a good way to build your portfolio and receive a regular income.
Equities are an asset class that covers shares of companies traded on the stock market. Technically, investing in equities means you are purchasing portions of companies.
This asset class carries higher risks since the value of a company share greatly depends on how the company is performing at the time you buy. However, from a historical point of view, returns have been higher on this market compared to bonds and cash equivalents.
Equities are the asset class that will make your portfolio grow. On the other hand, the higher risks mean you can lose large amounts of money if a company underperforms or if an entire sector of the market is in bad shape.
Follow these simple rules to make wise decisions when investing in equities:
- Equities perform well when the economy is in good shape and when inflation is low. If the inverse is true, focus on other asset classes for a while.
- Create a diversified equity portfolio. Invest in multiple companies and in various sectors. Diversifying your investments will lower the risks associated with equities, but will not be enough if the economy as a whole is in bad shape.
- Do your research. Always look at historical data and do research on the company you want to invest in before buying shares.
Stocks are a popular option, but consider these investment products from this asset class as well:
- Mutual funds. These funds invest in a collection of stocks to give you exposure to a wider slice of the market.
- Index funds. These funds invest in all the stocks that constitute a particular index to reproduce the movements of the designated market as a whole.
Investing in these funds usually carries lower risks than purchasing individual shares.
It’s possible to save for retirement with a portfolio that includes these three asset classes, without ever holding any physical investments. However, investing in a physical asset is a good way to create diversification outside of the financial institution you trust with your portfolio.
Real estate is by far the most popular type of investment in this asset class. With real estate, you can get growth from the appreciation of your properties and regular income from renting out your properties.
There are some disadvantages to investing in real estate, including high maintenance fees, the possibility of a property losing its value, and the fact that being a landlord is a lot of work.
Precious metals are another popular physical asset. You can build a collection of coins and bullion over the years and even deposit qualifying coins and bullion into an IRA if you no longer want to store them in your home.
Other investors see art, classic cars, and other collectibles as good ways to save for retirement. Even though these markets are unpredictable, you can definitely make a profit from these investments as long as you’re an expert on the kind of items you invest in.