Understanding how to categorize one’s holdings properly can greatly assist investors in diversifying their portfolios. Investors can watch investments and decide on future investments if they know how different investment groupings fit into other asset classes. Therefore, in this article, we will discuss the definition of an asset class as well as seven distinct types of asset classes.
List of Contents
What Exactly Is an Asset Class?
A class of assets is a group of investments with similar characteristics regarding risk, growth potential, and sensitivity to market swings. They are a method for categorizing comparable securities, partly for investing strategy objectives. Diversification of one’s investment portfolio, a fundamental principle of investing, is easier to comprehend and implement due to asset classes. The following are some of the most common and popular asset classes seen in investment portfolios.
- Cash and cash equivalents
- Equities
- Fixed-income securities
- Real, tangible assets
- Commodities
Notably, most asset classes are divisible into a more significant number of subcategories. Additionally, relatively recent investing opportunities such as cryptocurrencies and other forms of digital assets have resulted in the creation of additional asset classes.
Working Principles of Asset Classes
Generally, asset classes are used by investors as well as investment advisors to form investment portfolios by particular investment objectives. Moreover, they are also used to assist with the diversification of their investment portfolios. Notably, this technique is referred to as asset allocation. In addition, investment vehicles in the same category have similar characteristics. These characteristics include taxation, risk, liquidity, market volatility, and returns. Since assets within the same asset class share similar characteristics, they often respond comparably to events that move the market.
Additionally, it is typically recommended that investors diversify their investment assets over a number of different asset classes to reduce the amount of risk and volatility associated with their investments. If the majority of your portfolio was invested in just one asset class, you could be in danger of suffering significant losses. Similarly, when one section of an investor’s total portfolio gets particularly large as a result of excellent performance, the investor would typically rebalance the share of the portfolio that is allocated to the various asset classes. They accomplish this goal by selling off a portion of their excessive holdings and investing the proceeds in additional holdings of one or more of the other asset groups.
Understanding the Various Types of Asset Classes
Individual investors should know of seven types of asset classes. All of them are described below.
1. Fixed-Income Securities
The investor of fixed-income security such as a bond receives a coupon payment on a predetermined schedule. Notably, a bond is comparable to a loan, with a critical difference. Importantly, you will receive a return on your initial investment in addition to interest. In most cases, purchasing bonds does not result in acquiring an ownership position in the company.
Pros
- Various bonds can offer income consistency and liquidity.
- Bonds are less volatile than other asset classes such as equities.
- Bonds pay an inevitable return to investors.
Cons
- Higher inflation can reduce the value of a bond.
- When interest rates rise, bond prices can fall.
2. Equities
Equities, often known as stocks, are stakes held by investors in a public company’s profits. A corporation is considered public if it has distributed its shares to the capital markets by participating in a public exchange. Examples of public exchanges include the New York Stock Exchange and the London Stock Exchange.
Pros
- In general, equities deliver above-average asset returns.
- Equities are often liquid assets that can be bought and sold quickly.
- Equities offer a variety of share classes, including large-cap, small-cap, and mid-cap.
Cons
- Equities give more volatile returns than other asset classes, including bonds.
3. Real Estate
Investing in property is one of the most common and time-honored ways to build wealth through asset classes. Residential real estate, commercial real estate, industrial real estate, and retail real estate are the four primary subcategories that make up the real estate asset class. Significantly, you can produce returns from real estate in various ways, including income from rent and capital gains from an increase in the value of your property. Moreover, you can also purchase shares in a real estate investment trust (REIT) or invest in a tangible real estate asset.
Pros
- Real estate ownership can bring tax advantages.
- You have total authority over your property.
- Tenants in real estate can give you monthly income.
Cons
- You must be knowledgeable about mortgages, titles, insurance, and property law.
- You must obtain money to achieve a significant return on investment.
- A vacancy can disrupt your financial flow.
- Liquidity can be uncertain.
4. Futures Contracts
A futures contract gives both the right and the obligation to buy or sell an underlying asset at a predetermined point. The trading of futures contracts often takes place on a supervised exchange. The exchange handles the reporting of transactions to the relevant authorities. An exchange will also include a description of the contract’s terms and conditions.
The underlying movements of assets such as commodities, equity indexes, shares, bonds, currencies, and cryptocurrencies are tracked via futures contracts. These underlying assets can include cryptocurrencies. While other futures contracts are monetarily resolved, others call for the actual delivery of the underlying asset at the agreed-upon place.
Pros
- You can employ leverage through a margin account.
- Futures exchanges offer clearance and reporting services.
- Futures contracts are regulated.
- Futures contracts have a high level of liquidity.
Cons
- The majority of brokers require a minimum deposit.
- The only time liquidity is active is when an exchange is open.
5. Commodities
Theoretically, commodities are fungible. This indicates that there is minimal distinction between them regardless of whether they come from two separate producers. In a physical market, it is possible to purchase and sell tangible commodities. For instance, you can buy gold and store it at home before selling it. Moreover, you can also purchase futures contracts, exchange-traded funds (ETFs), or contracts for difference (CFDs) that provide exposure to certain commodity items. They are divided into the following subcategories.
- Precious metals
- Base metals
- Energy
- Agriculture
- Soft commodities
Pros
- Commodities can offer higher returns than other asset classes.
- Commodities provide diversification.
- Commodities can provide protection from rising inflation.
Cons
- Commodities can be quite volatile.
- Most commodities do not provide any income generation.
6. Cryptocurrencies
Generally, cryptocurrencies are electronic money. Some are used as payment funds to purchase products and services. Some cryptocurrencies grant access to various platforms. Notably, there are several ways to trade cryptocurrency. You can use your coins to make payments if you open a digital wallet. Contracts for difference can be used to trade the movements of specific cryptocurrencies.
Pros
- There are several ways to trade cryptocurrency.
- Most cryptocurrencies have adequate liquidity.
- They can be used to diversify your portfolio.
Cons
- Cryptocurrencies are a relatively new asset class, and adoption has been slow.
- Cryptocurrencies are extremely volatile.
7. Cash
Cash or a cash equivalent is highly liquid money. When investors discuss cash returns, they are referring to the returns that may be obtained from a money market or bank account. The returns are not calculated using the value of physical cash stored in a personal safe.
Pros
- Cash holdings enable you to take advantage of other investment possibilities when they arise.
- Cash can reduce portfolio volatility.
- Cash is the most liquid asset kind that you may own.
Cons
- Cash has an extremely low return on investment in general.
Asset Classes and Diversification
Genuinely, you are not required to certainly know which asset class a particular investment belongs to. You need only comprehend the fundamental concept or generic kinds of investments. This discovery is significant due to the notion of diversity. Diversification is the technique of lowering total risk by investing in several asset groups.
Importantly, there is often little correlation between asset classes or an inverse or negative correlation. Bonds, real estate, and commodities may underperform during periods of strong equity performance. During a bear market in stocks, investors may see above-average returns from other assets, such as real estate or bonds. Moreover, you can reduce your risk exposure and hedge your assets in one asset class by holding investments in other asset types simultaneously. Asset allocation is the process of decreasing investment portfolio risk by diversifying investments across several asset types.
Asset Allocation and Risk Tolerance
The main reason for having a fundamental understanding of asset classes is to enable you to comprehend the characteristics of the various investments you may choose to trade. For instance, you may allocate all or virtually all of your investing capital to futures trading or other financial derivatives such as a foreign exchange. However, you must be cognizant that you have chosen to trade a type of asset that is typically regarded as significantly riskier than bonds and stocks.
The amount you adopt asset allocation as a measure of diversification will be a personal choice influenced by your specific investment objectives and risk tolerance. If you are highly risk-averse, you may invest exclusively in asset classes that are generally safe. You may seek diversification within a particular asset class. Commonly, stock investors diversify by holding a variety of large-cap, mid-cap, and small-cap stocks. They may also attempt diversification by investing in unconnected market segments.
Conversely, suppose you have a high-risk tolerance and are flush with cash. In that case, you may care less about diversification and be more concerned with identifying the asset class that currently offers the highest prospective returns.
Conclusion
In conclusion, a wide variety of diversifiable asset classes are available for investment. Each type of asset has several advantages and disadvantages. You may create a diversified portfolio that has the potential to perform well over time and in a variety of market conditions by holding a few different asset classes from a wide range of investment options.
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Source: thebalance, currency.com