WHAT ARE ASSET CLASSES?

There are many different types of investment products. Once you understand their characteristics and how they normally perform in the market you may start to have an idea of which ones are appropriate for you. While some investments might appear very different from one another others can be similar. In fact investments that share similar characteristics are grouped together under one umbrella. We call this umbrella an asset class. Different asset classes may offer different risk and return but make no mistake each one comes with uncertainty and risk. Asset classes tend to change in value over time in different ways. For example when on asset class goes up in value another may not move as much or it might even moved own in price. Correlation measures how closely the value of two investments changes over time. If two investments are perfectly correlated they will always increase or decrease in value at the same rate and time. Today we’ll go over four common asset classes: equities, fixed income, cash equivalents, and alternative investments like real estate or other tangible assets.

A diversified portfolio may contain a mix of each one but investors can weigh more heavily on on asset class over another based on their investor profile and investment objectives. Let’s run through each asset class.

Equities Asset Class.

An example of a type of security that falls into this asset class is stock. One similarity among equities is ownership. For example if Tom buys stock shares from a popular retail clothing company he will be given partial ownership of that company. Historically equities have had the highest long-term returns over other asset classes but they have also had the highest degree of volatility and risk when compared to fixed income and cash.

Fixed Income Asset Class

Bonds are an example of a type of security in this asset class. One similarity among different fixed income securities is interest income. This is the interest that investors earned over a period of time. For example to raise funds to upgrade their power plant XYZ corporation issues a one hundred thousand dollar bond to Tom for four years. The borrower in this case XYZ corporation promises to pay five percent annual interest to the lender Tom. At the end of the four years Tom will receive twenty thousand dollars in interest or five thousand dollars a year for four years plus the one hundred thousand dollar principal back. Compared to equities fixed income securities usually come with less risk and lower returns.

Cash and Cash Equivalents Asset Class.

Cash and certain guaranteed investment certificates or GICs are examples that fall under this asset class. These types of securities are liquid meaning investors can usually withdraw funds fairly quickly if they need them like if an emergency were to arise for example. Compared to equities and fixed income cash and cash equivalents have the lowest risk profile and the lowest returns.

Alternative Investments Asset Class.

This class includes assets like real estate investment trusts, commodities like gold or oil, or aggressively managed funds called hedge funds. These types of assets can widely vary in both risk and return from very low to very high. Each asset class has their own distinct advantages and disadvantages that relate to a number of factors like liquidity and inflation and all come with various levels of risk and reward.

Now that we’ve covered the basics of each asset class how can you apply this knowledge to your portfolio construction?