Once you start thinking about investing, you’ll hear the term “asset class” come up a lot. Put simply, an asset class is a group of similar assets or investments. The difference between the main asset classes when building your portfolio will affect your investment returns and your risk level.
What are asset classes?
Asset classes are groups of assets that are similar. While US stocks, international stocks, blue-chip stocks, stocks from emerging markets like India, industrial stocks, technology stocks and mining stocks are all different stocks, they belong to the same class. This is because they are similar in the way they are bought and sold through an exchange, are regulated in the same way and all have similar tax implications.
There are five main asset classes.
Equities
Equities include all stocks and funds listed on a public exchange like the S&P 500 or the NASDAQ. These are publicly listed companies, and when you buy shares in these companies, you own a portion of it. Equities are often considered to be the highest-risk asset class.
Types of stocks
When you buy stocks, you’re buying a share of ownership in a company. Also called equities, stocks are based on the company type, size, potential for growth and performance in the market.
Your profits and losses depend on the success and failure of the company, as well as the influence of major trends in the stock market.
- Income stocks. These pay regular dividends based on the company’s current or retained earnings. For investors, they provide high-yield income that’s often paid out quarterly. Big-name utility companies tend to be income stocks.
- Growth stocks. These are stocks of companies growing at a faster rate than the market average, such as tech startups. They rarely pay dividends. Instead, investors purchase them because they believe their capital will appreciate.
- Value stocks. These are shares of companies with lower price-to-earnings (PE) ratios than their peers, so they’re often cheaper than stocks with a higher PE. They can be growth or income stocks, and people buy them hoping the stock price will rebound and return to a more competitive PE.
- Blue-chip stocks. These are shares in huge, financially fit corporations with a solid history of growth, and they usually pay dividends. Examples of blue-chip stocks are General Electric, Visa and Walmart.
- Master limited partnerships. MLPs are publicly traded companies organized as limited partnerships. They combine the benefits of having profits taxed only when investors receive distributions with the liquidity of a public company.
- Penny stocks. As the name suggests, these are small shares of public companies that trade for less than $1. They’re known for their volatility.
- Impact stocks. Impact stocks are shares in companies that are known for their environmental and social stewardship. Companies specializing in solar energy, low-income housing and sustainable agriculture are examples of impact stocks.
Fixed-income securities and debt
Fixed-income assets offer a fixed rate of return, like bonds. Bonds are essentially a form of loan used by both companies and governments when they need to borrow money. Investors who lend their money will earn a preset, fixed interest rate on that money.
Types of bonds
Bonds are a type of fixed-income investment that pay interest or dividends at set intervals and return your principal amount at the end of the term. They are issued by governments and companies at fixed rates, so when you buy a bond, you’re essentially lending the issuer money in exchange for interest payments. Bonds are generally less risky than stocks, but like any investment, your returns may vary, so there’s no guarantee you’ll make money.
Government bonds
There are two different types of government bonds: treasury bonds and municipal bonds. Both are used to generate money for cash flow, finance debt, fund investments and more. They are issued by the government, so they are the lowest risk, but they often have lower interest rates than the other types of bonds.
US Treasuries
These bonds are issued by the federal government through the US Department of the Treasury. There are four types of US treasury bonds that range from short-term to long-term and have different risk levels and returns.
- US Treasury Bills. Short-term securities that mature within 52 weeks.
- US Treasury Notes. Long-term securities that mature within 10 years of being issued.
- US Treasury Bonds. Even longer-term securities that mature within 30 years and pay interest every six months.
- Treasury Inflation-Protected Securities (TIPS). Notes and bonds whose principal is adjusted for inflation according to the Consumer Price Index. They are issued for terms of 5, 10 and 30 years, and pay interest every six months.
Municipal bonds
Municipal bonds are issued by states, cities, counties and local governments. They are all used to finance capital expenditures, but the purpose and repayment plan will vary.
- Revenue bonds. Often used to fund public projects like water treatment plants or toll roads, revenue bonds are repaid by the revenue generated from the project.
- General obligation bonds. These bonds are not backed by revenue from a specific project and are repaid through general taxation and municipal revenue or funds.
- Conduit bonds. These bonds are issued on behalf of private companies like non-profit colleges or hospitals and backed by the third party as opposed to the government.
Corporate bonds
Corporate bonds are issued by public companies in an effort to generate cash flow. Unlike stocks, you won’t own a share of the company but will instead be considered a creditor and will earn interest on top of your principal. These bonds usually offer higher returns than government bonds, but they’re also riskier — if the company fails, it may default on the debt.
- Investment-grade bonds. These bonds have a high credit rating, meaning that the issuer is likely in a strong financial position with the ability to repay the investment.
- High-yield bonds (junk bonds). These bonds have a lower credit rating but pay higher interest rates in exchange for the increased risk.
- Convertible bonds. These bonds can be converted to a predetermined amount of common stock or cash.
Cash and money market
This is the lowest-risk asset class and includes deposits with banks via products like savings accounts and CDs.
- Savings bonds. These debt securities are issued and backed by the US Department of the Treasury to help pay for the federal government’s borrowing needs.
- Savings accounts. Most banks and credit unions offer insured savings accounts that pay compound interest. You can make as many deposits as you like, but withdrawals are typically restricted to six each month.
- Money market accounts. MMAs can take your savings to the next level by offering the convenience and liquidity of a high-interest savings account, sometimes with checkwriting privileges, but often in exchange for higher initial deposit and balance requirements.
- Certificates of deposit. Look to a CD for an insured savings account that holds a set amount of money for a fixed term, usually six months to five years. The issuing bank pays interest until the CD matures. You can cash in your CD for the principal plus the interest you earned or roll over your balance to a new CD.
- 529 plans. Also known as qualified tuition plans, 529s are savings plans sponsored by states, state agencies or educational institutions. Earnings grow tax-deferred and withdrawals are tax-free when used for qualified education expenses, such as tuition and board.
- Cash-value life insurance. Permanent life insurance policies — like whole, universal and variable life insurance — are investment products that build value over time. They include a cash component that’s invested into a menu of options, usually mutual funds. When you die, your beneficiaries receive a death benefit plus any added cash value.
- Annuities. Think of an annuity as a contract between you and an insurance company. The company promises to pay you regularly either right away — called an immediate annuity — or as a future deferred annuity. Annuities grow tax-deferred, and you won’t pay taxes on the income and investment gains until you withdraw the money. Many people buy fixed, variable or indexed annuities to help manage money in retirement.
- Precious metals. Investors often buy precious metals like gold, silver and platinum to diversify their portfolios and protect themselves from inflation and financial instability. Precious metals have intrinsic value, so they’re not susceptible to inflation simply because you can’t print more of them. Because they’re separate from assets like stocks and bonds and carry no credit risk, they’re a less volatile investment.
Property
This includes property investments in residential homes and commercial property — like major offices or industrial buildings. This is known as unlisted property, as it’s not bought and sold on an exchange like stocks and bonds are.
However, you can invest in listed property with a managed fund, investing in a range of properties. Although you access listed property on an exchange, it’s still considered part of the property asset class, rather than equities.
Types of real estate
Buying a home is among our major investments. But other investment options make up the real estate realm.
- Rental real estate. This involves buying and operating a real estate property, such as a house or apartment building, so that you can collect the rent. Many investors go with this investment for its cashflow income.
- Real estate investment trusts. REITs allow you to invest in large-scale, income-generating real estate, such as shopping malls, hotels, resorts and storage facilities. As the investor, you earn a share of the income that’s produced. Many REITs are registered with the SEC or publicly traded.
- Farmland and timberland investments. Investors who want to hold a tangible asset can purchase ownership tree farms, managed natural forests and similar investments.
New fintech innovations that allow you to invest in real estate without the hassle of managing it include Fundrise, PeerStreet and Patch of Land.
Alternative assets
Alternative assets are harder to identify, but they typically include assets that don’t fit into any of the above classes. For example, investments made into a private company — one that isn’t listed on an exchange — would be classed as an alternative asset. Another example is collectibles like antiques, art or a stamp collection.
Commodities like gold and other precious metals, grains and other agricultural products are sometimes included in the alternative asset class. You can purchase these directly or through exchanges. Additionally, currencies — and now cryptocurrencies) — are sometimes classified as an asset class, and are traded on their own foreign exchange market.
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How risky is each asset class?
All investments carry some risk, but some are riskier than other. Cash and money market accounts tend to carry the lowest risk, while equities and alternatives are generally the riskiest.
Defensive vs. growth assets
Group these five asset classes further into either defensive or growth assets. Defensive assets are lower risk and often offer investors a level of guaranteed income. Growth assets are riskier and typically aim to achieve capital growth over the longer term rather than income over the short term.
While returns are never guaranteed, it’s expected that high-risk growth assets will outperform lower-risk, defensive assets over the long term.
Defensive assets
- Fixed income
- Cash
Growth assets
- Equities
- Property
- Alternative assets
Investing for income vs. capital growth
You could also divide the assets up depending on whether you’re investing for income or capital growth. Income assets provide ongoing income while you hold the asset. Capital growth assets may not provide any income for the short to medium term, but the investor hopes it will grow so when it’s sold to make a profit.
One asset class can include both income and capital growth assets. Let’s look at stocks as an example. An established blue-chip stock like Coca Cola or IBM that profits every year and consistently pays a large dividend to its shareholders is classed as an income asset, as it offers value while you’re holding it. However, stock in a newly listed tech startup that pays no dividends are classed as a capital growth asset. Shareholder buys it with hopes it’s value will increase over the longer term.
What is an underlying asset?
You’ll often hear the term “underlying asset” in relation to some investment products like exchange-traded funds (ETFs), mutual funds and derivatives like options and futures. These products all track the value and performance of a particular set of assets, known as the underlying assets, often even if you don’t own that asset.
Let’s look at ETFs, for example. These are types of funds that track the performance of a basket of assets — often stocks that belong to a market index or futures contracts. So a S&P 500 ETF will track the S&P 500 index, which is the value of the top 500 companies in the nation. If you invest in the ETF, you’ll get exposure to these 500 stocks (the underlying assets) without actually owning any of them directly.
Why should I invest in a range of asset classes?
Each asset class offers a different level of risk, and aren’t affected by the same market conditions. This means factors that might make stock prices fall or rise could have little impact on other asset classes like cash and property. Since they rise and fall at different times, investing in a range of asset classes can help make your portfolio less volatile.
Funds
An investment fund collects capital from a bunch of investors to buy stocks, bonds and securities. Usually managed by professionals, they give investors access to opportunities they may not have been able to invest in on their own.
How to find the right mix of assets for your portfolio
When designing your portfolio, take the following factors into consideration.
- Your risk tolerance. If risky assets are going to keep you awake at night, it might be best to invest in asset classes that are lower risk.
- Your income and growth goals. Why are you investing? Do you want to earn a regular income stream now or are you investing for well into the future?
Bottom line
Understanding the various asset classes can help you build the right portfolio. When you’re ready, compare your investment options and check out the online trading accounts that fit your investing profile and goals.
