What Is an Asset Class?
An asset class is a grouping of investments that exhibit similar characteristics and are subject to the same laws and regulations. Asset classes are thus made up of instruments that often behave similarly to one another in the marketplace.
Examples of common asset classes include equities, fixed income, commodities, and real estate.
Key Takeaways
- An asset class is a grouping of investments that exhibit similar characteristics and are subject to the same laws and regulations.
- Equities (e.g., stocks), fixed income (e.g., bonds), cash and cash equivalents, real estate, commodities, and currencies are common examples of asset classes.
- There is usually very little correlation and sometimes a negative correlation among different asset classes.
- Financial advisors focus on asset class as a way to help investors diversify their portfolios.
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Understanding Asset Classes
Simply put, an asset class is a grouping of comparable financial securities. For example, IBM, MSFT, and AAPL are a grouping of stocks. Asset classes and asset class categories are often mixed together. There is usually very little correlation and sometimes a negative correlation among different asset classes. This characteristic is important in the field of investing.
Historically, the three main asset classes have been equities (stocks), fixed income (bonds), and cash equivalent or money market instruments. Currently, most investment professionals include real estate, commodities, futures, other financial derivatives, and even cryptocurrencies in the asset class mix. Investment assets include both tangible and intangible instruments that investors buy and sell for the purposes of generating additional income, on either a short- or long-term basis.
Financial advisors view investment vehicles as asset-class categories that are used for diversification purposes. Each asset class is expected to reflect different risk and return investment characteristics and perform differently in any given market environment. Investors interested in maximizing return often do so by reducing portfolio risk through asset class diversification.
Financial advisors will help investors diversify their portfolios by combining assets from different asset classes that have different cash flow streams and varying degrees of risk. Investing in several different asset classes ensures a certain amount of diversity in investment selections. Diversification reduces risk and increases your probability of making a positive return.
The main asset classes are equities, fixed income, cash or marketable securities, and commodities.
Types of Asset Classes
The most common asset classes are:
Cash and Cash Equivalents
Cash and cash equivalents represent actual cash on hand and securities that are similar to cash. This type of investment is considered very low risk since there is little to no chance of losing your money. That peace of mind means the returns are also lower than other asset classes.
Examples of cash and cash equivalents include cash parked in a savings account as well as U.S. government Treasury bills (T-bills), guaranteed investment certificates (GICs), and money market funds. Generally, the greater the risk of losing money, the greater the prospective return.
Fixed Income
Fixed income is an investment that pays a fixed income. Basically, you lend money to an entity and, in return, they pay you a fixed amount until the maturity date, which is the date when the money you initially invested (the loan) is paid back to you.
Government and corporate bonds are the most common types of fixed-income products. The government or company will pay you interest for the life of the loan, with rates varying depending on inflation and the perceived risk that they won’t make good on the loan. The risk of certain governments defaulting on their bonds is very unlikely, so they pay out less. Conversely, some companies risk going bust and need to pay investors more to convince them to part with their money.
Equities
When people talk about equities, they are usually speaking about owning shares in a company. For companies to expand and meet their objectives, they often resort to selling slices of ownership in exchange for cash to the general public. Buying these shares represents a great way to profit from the success of a company.
There are two ways to make money from investing in companies:
- If the company pays a dividend
- If you sell the shares for more than you paid for them
The market can be volatile, though. Share prices are known to fluctuate, and some companies may even go bust.
Commodities
Commodities are basic goods that can be transformed into other goods and services. Examples include metals, energy resources, and agricultural goods.
Commodities are crucial to the economy and, in some cases, are viewed as a good hedge against inflation. Their return is based on supply and demand dynamics rather than profitability. Many investors invest indirectly in commodities by buying shares in companies that produce them. However, there is also a huge market for investing directly, whether that is actually buying a physical commodity with the view of eventually selling it for a profit or investing in futures.
Each asset class carries a different level of risk and return and tends to perform differently in a given environment.
Alternative Asset Classes
Equities (stocks), bonds (fixed-income securities), cash or marketable securities, and commodities are the most liquid asset classes and, therefore, the most quoted asset classes.
There are also alternative asset classes, such as real estate, and valuable inventory, such asartwork, stamps, and other tradable collectibles. Some analysts also refer to an investment in hedge funds, venture capital, crowdsourcing, or cryptocurrencies as examples of alternative investments.That said, an asset’s illiquidity does not speak to its return potential; it only means that it may take more time to find a buyer to convert the asset to cash.
Asset Class and Investing Strategy
Investors looking for alpha employ investment strategies focused on achieving alpha returns. Investment strategies can be tied to growth, value, income, or a variety of other factors that help to identify and categorize investment options according to a specific set of criteria.
Some analysts link criteria to performance and/or valuation metrics such as earnings-per-share (EPS) growth or the price-to-earnings (P/E) ratio. Other analysts are less concerned with performance and more concerned with the asset type or class.
Investors are often advised not to put all their eggs into one basket and invest in different asset classes to spread their bets and reduce risk.
What are the most popular asset classes?
Historically, the three main asset classes have been equities (stocks), fixed income (bonds), and cash equivalent or money market instruments. Currently, most investment professionals include real estate, commodities, futures, other financial derivatives, and even cryptocurrencies in the asset class mix.
Which asset class has the best historical returns?
The stock market has proven to produce the highest returns over extended periods of time. Since the late 1920s, the compound annual growth rate (CAGR) for the S&P 500 is about 6.6%, assuming that all dividends were reinvested and adjusted for inflation.
In other words, $100 invested in the S&P 500 on Jan. 1, 1928, would have been worth about $42,500 (in 1928 dollars) by Dec. 31, 2022, without adjusting for inflation. The total would have grown to $727,560 in 2022 dollars. By comparison, the same $100 invested in five-year Treasuries would have been worth only a little more than $7,000 in today’s dollars.
Why are asset classes useful?
Financial advisors focus on asset class as a way to help investors diversify their portfolios to maximize returns. Investing in several different asset classes ensures a certain amount of diversity in investment selections. Each asset class is expected to reflect different risk and return investment characteristics and perform differently in any given market environment.
The Bottom Line
An asset class is a grouping of investments that exhibit similar characteristics and that may be subject to the same rules and regulations. Equities, fixed income, commodities, and real estate are common examples of asset classes.
Asset classes can be used to diversify portfolios and reduce risk, as they are expected to reflect different risk and return characteristics. For instance, if stocks are falling, bond prices may be rising, and vice versa. Building a portfolio with asset classes that are not highly correlated with one another is an important concept for diversification.
