Warren Buffett has the perfect investment mantra: Never put all your eggs into one basket. With this simple analogy, the Oracle of Omaha neatly expresses the importance of asset diversification. Asset diversification – the practice of allocating investments across multiple ‘asset classes’, is vital for investors because it helps them minimise their investment risk while also achieving long-term investment objectives.
What is an Asset Class?
An asset is any resource that has tangible economic value or could create this value in the future for an investor. Since assets are expected to provide some benefit, investors aim to add more assets to their investment portfolios by investing in one or more asset classes.
An asset class refers to a grouping of investment instruments or securities that:
- Have some similar traits
- Are usually traded in the same financial markets
- Often experience similar market fluctuations
- Behave in similar ways
- Are subject to similar (or the same) laws and regulations
Most financial and wealth advisors advise asset class diversification to help their clients reduce the risk of losses and maximise the probability and quantum of returns.
The 5 Most Popular Asset Classes
Here are the most popular asset classes and their key characteristics:
1.Equity
When investors invest in equity or stock, they purchase partial or percentage ownership into a publicly-traded company. These shares are traded on a stock exchange like NSE or BSE.
Partial ownership in an organisation enables an investor to share the company’s profits. However, this growth is not certain so there’s no guarantee that they will enjoy the financial benefits of investing in that company. Further, all publicly-listed businesses are subject to market fluctuations which can impact share price and ultimately, the investor’s returns.
- Equity and ELSS
Indian investors who want to invest in equity and reduce the impact of volatility can invest in Equity Linked Savings Schemes (ELSS). ELSS is a type of mutual fund that invests in equities on behalf of the investor. Since investors don’t invest directly in a company can reduce risk and get more stable and predictable returns. With some ELSS funds, they can also save tax under Section 80C.
2. Bonds or Fixed Income Assets
Fixed income assets are a widespread and trusted form of investments because they are less risky than equities and some other asset classes and tend to yield more predictable returns. The investor lends their money to a company or government entity for a specified period by purchasing a fixed-income asset. Unlike with equities, the investor does not get part ownership in the borrower’s organisation. However, they do earn interest, usually at some fixed time interval.
In India, the most popular fixed-income assets are:
- Bank fixed deposits (FDs)
- Public provident funds (PPF)
- Post office recurring deposits
- Post office monthly income schemes
Globally, many other types of fixed-income assets are available, including:
- Certificates of Deposits (CDs)
- Corporate bonds
- Municipal bonds
- T-bills, T-notes, T-bonds
- Fixed income mutual funds
Many investors prefer fixed-income assets to diversify their portfolios at minimal risk. However, these assets create several challenges for advisors, HNIs/family offices, and issuers. For example, advisors often struggle to access updated information about available options that can benefit their clients. Similarly, HNIs want to build long-term wealth but don’t know which fixed-income asset can help, while issuers cannot permanently raise capital most seamlessly or efficiently.
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3. Money Market Instruments
Money market instruments are also known as “cash equivalents” because they can be easily converted into cash. However, since they are only traded over the counter, investors must purchase them through a broker or a money market mutual fund (MMMF).
MMMFs are most suitable for investors looking to manage their short-term cash requirements. The fund manager invests in liquid instruments, and the investors (aka unit-holders) earn interest. These instruments may include:
- CDs
- Commercial Papers (CPs)
- T-bills
- Repurchase agreements (Repos)
4. Commodities
Commodities refer to any raw materials or goods that are traded on financial markets, such as:
- Gold
- Silver
- Energy resources: petrol, oil, natural gas
- Crops: wheat, rice, cotton
Commodity funds invest in these goods or in the companies that produce them. They provide a good opportunity for portfolio diversification and protect investors against inflation with potentially high returns. Futures-based commodity funds don’t directly invest in commodities but offer exposure to them by investing in futures contracts.
In addition to these five asset classes, another class has emerged in recent years: alternative investments. Examples of these investments include hedge funds, artwork, and digital assets like Non-Fungible Tokens (NFTs). Most of these assets can generate very high returns. However, they are also highly risky and have a high probability of losses.
5. Real Estate
As an asset class, real estate includes residential, commercial, or industrial properties, such as:
- Home
- Factory
- Office
- Villa
- Residential or commercial building
- Plot
Real estate rarely depreciates in value, so this asset can yield very high returns for an investor if they lease it out and even when they sell it outright. Moreover, these returns are almost always higher than inflation.
Comparing the Different Asset Classes
Each asset class has unique characteristics concerning risk, potential returns, liquidity, and market volatility. Here is a quick comparison of the various asset classes based on these characteristics:
| Asset class | Risk | Potential Returns | Investment Horizon | Liquidity | Advantages | Disadvantages |
|---|---|---|---|---|---|---|
| Equity | High | High | Short, medium, long term (Depends on the investor and their investment goals) | Liquid | Probability of high returns | Highly susceptible to market volatility Can result in lower returns and even heavy losses |
| Fixed income | Moderate | Low-medium | Short to medium term | Liquid | Predictable, steady & inflation beating returns Low risk of losses | Moderate and fixed returns |
| Money market instruments (MMMFs) | Low | Medium-High | Short term | Highly liquid | Less susceptible to market volatility Easy exits Suitable for investors with low-risk appetite and surplus investable cash | Not suitable for investors with a medium-term or long-term investment horizon |
| Real estate | Higher than fixed income Lower than income | High | Medium to long term | Highly illiquid | Can yield very high returns over the long term Protects against inflation | Requires a fairly large investment, hence unsuitable for investors with a small investment corpus Asset value depends on multiple unpredictable factors, e.g., government regulations, socio-political situation, etc. |
| Commodities | Medium to high | Medium to high (Depends on the underlying commodity and its demand) | Long term | Highly liquid | Protects against inflation | Highly susceptible to market volatility Not suitable for investors with low risk tolerance or long-term investment horizon |
Conclusion
As we have seen, many asset classes differ in terms of risk, average returns, liquidity, investment horizon, and susceptibility to market volatility. When choosing an asset to invest in, there is no ‘right’ or ‘wrong’ answer because the choice would depend on several factors, including the investor’s goals, risk appetite, and desired returns.
First-time or inexperienced investors can benefit from the experience and advice of investment advisors. In the case of fixed-income assets, a platform like Yubi Invest can create many advantages for advisors and ultimately, their clients.
