Asset classes are different categories of investment vehicles. Investing in multiple asset classes will diversify a portfolio and should curtail some of its risk.
Asset allocation decisions have a real impact on the investing experience. Industry studies show that 90% or more of the variability in returns is driven by asset mix. This refers to volatility and not returns; investors need to be comfortable with portfolio fluctuations in order to stick to their target asset allocation over the long term.
There is no universal set of asset classes, but these 4 are considered the most common major asset classes:
- Cash and Equivalents
- Bonds or Fixed Income
- Stocks or Equities
Cash and equivalents
Cash is well…cash. Cash equivalents are investments easily convertible into cash, like commercial paper, money market instruments and guaranteed investment certificates (GICs). Investors hold cash for liquidity purposes and to cover near-term expenses that will be incurred within two years. Cash and equivalents keep money safe during downturns.
They also give holders easy access to their money and don’t typically cost much to own. They are widely considered low or no risk since any such holdings are often guaranteed by a strong issuer or a government program like deposit insurance.
The caveat is that this asset class produces lower returns versus the others. Investors’ return on cash and equivalents come from the interest paid on these vehicles, which tends to be amongst the lowest payout rates of any interest-bearing investments. We know that risk is synonymous with reward, which is why there’s limited risk from holding cash and equivalents.
With cash equivalents, the major risk is that the issuer is unable to repay the debt at maturity. Before investing, investors would be wise to evaluate the issuer, as well as the business and economic climate.
Bonds or Fixed Income
Bonds are the most common type of fixed income investment, but there are other fixed income vehicles, such as certificates of deposit. Government bonds, including Treasuries, are categorized as fixed income unless they mature in less than 90 days, in which case they’re considered cash equivalents.
Fixed income securities are essentially a loan to a company or government. When investors buy a bond, they agree to lend the money for a certain amount of time, known as the term. In exchange, the borrower pledges to return the principal and make regular interest payments. These occur on a fixed schedule and maturities can range up to 30 years.
Investments in fixed income securities are subject to various risks, including changes in interest rates, credit quality, or liquidity. Prepayment, early redemption, corporate events, and tax ramifications are other factors to consider.
The main risk with bonds is that the issuing company, government or government agency defaults or is somehow unable to repay the loan. Investments in lower-rated and non-rated securities are more at risk of loss than higher-rated securities — the risk versus reward construct at work. Bear in mind that the risk of default is quite low when it comes to government-backed bonds issued in developed nations.
As the name suggests, yields on fixed income assets are fixed, but there is the potential for capital appreciation with bonds.
Stocks or Equities
Stocks or equities are ownership shares of a publicly-traded company and investors who buy them own a share of a company and participate in its gains, losses and/or dividend payments.
The two categories are common and preferred. With common stock, investors may receive dividends, but they’re not guaranteed and common shareholders get repaid last, if at all, in the event of bankruptcy or corporate reorganization. Meanwhile, preferred shareholders receive fixed dividend payments and have priority over common shareholders, but this doesn’t mean they’ll be repaid in full because the bondholders are ahead of preferred shareholders.
When a company appreciates/depreciates in value, its shares are worth more/less. The value of a stock will rise or fall based on the company’s performance — largely determined by corporate earnings, as well as dividends, the level of demand for the company’s stock, its growth potential, and a host of other factors.
Ideally, stocks increase in value over time, creating a positive return for investors. Investors must sell stock to realize those capital gains, because until sold they’re “paper gains”.
Equities are affected by stock market fluctuations that occur in response to economic and business developments. So, while this asset class can offer high returns, it comes with higher risk. Investors can lose money in stocks, up to their entire investment. If investors want growth, they must accept the accompanying volatility of stocks.
Alternatives are essentially any investment that isn’t a stock or a bond, or a pooled vehicle — like a mutual fund or ETF — that invests in the other three asset classes. They are the newest asset class, but not all that new for some types, like hedge funds, infrastructure, and private equity.
They are structured in many different ways in terms of how they work, how they generate returns and how much is needed to invest. The appeal of alternatives stems from generally higher potential rates of return and that their return profiles differ from those of stocks or bonds or cash.
The two categories of alternatives are alternative assets and alternative strategies. Alternative assets invest in physical assets, like real estate or commodities while alternative strategies use different investment approaches, like long/short or market neutral.
Alternative assets tend to be complex and trade infrequently, if at all. Examples include:
● Real Estate
● Collectibles (e.g. art and wine)
Alternative strategies tend to trade more readily and employ non-traditional methods like short selling and leverage. Examples include:
● Hedge Funds and Absolute Return Strategies
● Real Estate Funds, including Real Estate Investment Trusts (REITs)
● Derivatives, including Futures, Forwards, Swaps, and Options
● Alternative Fixed Income, including Mortgage Investment Corps (MICs)
● Long/Short Funds
● Managed Futures
Some alternatives offer regular payouts, like alternative fixed income while others offer only the potential for price appreciation.
In some cases, alternative investments can be sold to lock in gains, but with some there is no ability to sell them and investors only get paid out when the investment is wound down, acquired or otherwise dissolved.
Correlations and portfolio risk
Investors can mitigate volatility by diversifying their portfolios, which is achieved by holding different asset classes. Cash and equivalents, fixed income, equities, and alternative assets aren’t affected by the same factors or even in the same way by a single factor.
Alternative investments are coveted for their lower correlation to stocks, bonds, and cash. This is how diversification can curtail volatility — different asset classes behave differently and based on different drivers.
Just remember the tradeoff between risk and reward; the greater an investor’s allocation to the more conservative asset classes, the more muted their potential returns will be. Protection from the devastating effect of a market crash means that same portfolio is unable to fully participate in equity market advances.
Understanding the major asset classes is important because this helps investors determine the right asset mix for them and that mix is a critical determinant of a portfolio’s risk level and growth potential.