Asset Classes

Updated: May 20, 2020

Depending on whom you ask, the list of asset classes will be different. For example, U.S. stocks and international stocks might or might not be considered to belong to the same asset class (stocks).

Major Asset Classes

Note that we could put inflation-protected securities into the bonds asset class. However, since their usage is different enough, we prefer to put them in a class of its own.

Stocks

When you invest in stocks (also called equities), you are investing in a company. 

“Investing in stocks” means buying shares of a company, even if it is a tiny piece.

You are expecting that the company will perform well and that, in consequence, the shares of the company you bought will appreciate in value.

It does not matter if you only own a tiny piece of the company shares. If the value of a company goes up, every shareholder will benefit.

Historically, stocks produced higher returns but also entailed higher risks.

If you invest in companies that are increasing in value, you could make a lot of money. The same way, if you invest in companies that are losing value, well, you could lose a lot of money.

Individual investors can buy shares directly or invest through an investment vehicle (a mutual fund, index fund, or ETF). 

Many aspiring investors put too much weight into stocks. Stocks are a great source of portfolio growth. But if you are starting to invest, it is prudent to combine stocks with other less risky asset classes.

Our goal here is NOT to encourage anyone to invest in stocks. The idea is to show that it is an option. Because, if used well, it can help you achieve your investment goals.

Bonds

Buying bonds is like lending money to a company or the government. You get the promise to receive your money back plus interest at a future date.

Government bonds normally pay less interest because there are fewer risks involved. Nothing is guaranteed, but chances are the government will pay you back without problems.

Corporate bonds are riskier than government bonds. Companies do not pay their debt sometimes. In turn, corporate bonds pay more interest to compensate for the higher risk.

There is a particular type of corporate bonds, called Junk Bonds, that are bonds issued by companies in financial difficulties. The interest they pay is a lot higher, but the risk of not getting your money back is a lot higher too.

Individual investors are better off by investing in bonds through an investment vehicle. You would need a lot of money to buy bonds directly. Besides, a fund offers greater diversification.

Bonds are also somewhat ignored by beginner investors. That is also a mistake, since bonds provide a great way to add stability and diversification to a portfolio.

Cash and Cash Equivalents

Well, cash is cash. There is not much else to say.

Cash equivalents are short-term securities that have high credit quality and high liquidity. In other words, they can be considered cash.

You can use cash or cash equivalents to increase your portfolio's liquidity or reduce its risk. Accordingly, you will also reduce its potential return.

This is probably the asset class beginner investors don't even consider. But that is a mistake. Cash can be very useful to control the overall portfolio risk.

Treasury Inflation-protected Securities (TIPS)

The inflation-protected securities pay the inflation rate plus interest. 

Maybe the best way to explain is with an example. Note that I am simplifying the calculations to make the example easier to understand. 

Let’s say the current inflation rate is 2%. Then, a government bond might pay 2.5% interest, and an inflation-protected security might pay something around inflation plus 0.5% interest.

In case 1, let’s say inflation rises to 3%.

The government bond’s holder will still receive the 2.5% interest. That would mean a 0.5% loss against inflation. 

The inflation-protected security’s holder will receive 3.5% (3% inflation plus the 0.5% interest). That is a 0.5% profit against inflation.

In case 2, let’s say inflation falls to 1%.

The government bond’s holder will still receive the 2.5% interest. That would mean a 1.5% profit against inflation. 

The inflation-protected security’s holder will receive 1.5% (1% inflation plus the 0.5% interest). That is the same 0.5% profit against inflation.

These securities present a good way to protect your portfolio against rising inflation.

Beginners don't always understand inflation-protected securities. But, beginner investor or not, it is always a good idea to take steps to protect your investment portfolio.

In the right proportion, these securities are a good way to add some extra protection.

Real Estate

In a way, many people are more comfortable investing in real estate than in other asset classes.

Investors in real estate aim to profit from collecting rents but also from rising prices (capital gains).

Real estate can add some protection against inflation, but it also brings additional risks.

For example, it can be difficult to sell real estate investments in a hurry.

Diversification is also an important issue since one needs a large amount of money to build a diversified real estate portfolio. 

You can invest directly in real estate, by buying a house for example.

Alternatively, you can invest in a real estate fund or REIT, which requires less money and might solve the diversification issue. 

Commodities

Commodities are physical goods like grains, gold, oil, and so on. 

Historically, commodities produced lower returns than stocks, but they offered diversification and some protection against inflation.

Unless you are a very sophisticated investor, you should avoid investing directly in commodities.

It is also a good idea to leave derivatives for professionals. If you want to invest in commodities, invest using a commodities fund instead.

Commodities are not normally listed in an Investing for Beginners guide, and I agree... it is better used by more experienced investors.

On the other hand, to present a better picture, I believe it is important that beginner investors understand all investing possibilities.  

Currencies

In simple terms, investing in currencies is like holding cash in a currency other than your country’s currency.

For example: if you live in the USA, putting part of your money into Euros is a currency investment. You would make money if the Euro becomes stronger against the Dollar, and would lose money if the Dollar becomes stronger against the Euro.

There are different ways to invest in currencies:

  • Holding cash in a foreign currency
  • Buying foreign assets (here you also have the asset risk)
  • Using derivatives (better left only for investment professionals)

It is important to note that it can be very risky to invest in currencies because currencies can be quite volatile. Many factors can affect currency prices.

I am talking about currencies here to provide a bigger picture.

If done well, investing a little bit in foreign assets might provide better portfolio diversification. However, unless you absolutely know what you are doing, better let currencies alone.

Exchange Traded Funds (ETFs)

Regarding the asset classes, one can make direct investments, use derivatives, or invest in funds, but most people are better off using ETFs. 

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About the author

Ricardo Ribeiro, PRM

Investment management professional with a career spanning more than 20 years in the financial sector. Adept at integrating market risk analyses into investment strategies. Committed to helping aspiring investors get to the next level, and to shaping the next generation of investment tools and models. Mr. Ricardo Ribeiro holds a Professional Risk Manager (PRM) designation from the Professional Risk Managers' International Association (PRMIA).

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