A diversified portfolio can help balance risk among your investments and provide the potential of more consistent returns over time. Asset class is one factor to consider when diversifying your portfolio.
What is an asset class?
An asset class is a grouping of investments that have similar characteristics. Examples include cash and cash equivalents, fixed-income investments (such as bonds), real assets (such as property and commodities) and equities (or stocks).
Types of asset classes
Following are the four most common asset classes available to investors today. They’re listed generally in order of least to most risk.
Cash and cash equivalents
Many investors hold cash as a way of maintaining liquid assets or simply providing safety and comfort in volatile times. Cash equivalents include cash-like products such as money market accounts, Treasury bills (T-bills) and commercial paper.
Return: Cash and cash equivalents are considered low yield compared with some other investments.
Risk: There’s little risk when it comes to holding cash. When it comes to investing in cash equivalents such as commercial paper, a major risk is that the issuer will not be able to pay the debt at maturity. Before buying commercial paper, you should consider the characteristics of the issuing company, the business climate of the company and the economy.
Fixed-income securities
These investments make fixed payments of income on a principal investment, with the principal returned at a specified future date. The most common fixed-income investments are bonds, but certificates of deposits (CDs) are also considered fixed income.
Return: As the name implies, the yield on fixed income assets is fixed. You can generally determine your expected return when you first invest, and you typically won’t make more than that.
Risk: The company or government entity issuing a bond could default and fail to repay the loan. Treasury bonds are considered a safer form of debt, since the U.S. government backs them.
Investments in fixed-income securities are also subject to various risks, including changes in interest rates. These investments typically decrease in value temporarily when interest rates rise. This risk is usually greater for longer-term securities.
Credit quality, market valuations, liquidity, prepayments, early redemption, corporate events and tax ramifications are other risks. For example, if you invest in lower-rated and non-rated securities, you have a greater risk of loss to principal and interest, through issuer default, than if you had invested in higher-rated securities.
Real assets
Real assets are based on tangible things, such as property and commodities. With property, investors might own office buildings, apartments or industrial complexes expressly to sell or rent for a return. Commodities refer to raw materials, such as oil, wheat or gold.
Return: Real assets can appreciate in value, but to realize returns, you may need to sell the asset. Investment properties can also provide substantial income, and because rents often increase with the cost of living, this can help combat inflation. Commodities earn return price changes driven by supply and demand versus a factor such as profitability for equities.
Risk: Investments in real estate can be subject to fluctuations in the value of the underlying properties, the effect of economic conditions on real estate values, changes in interest rates and risks related to renting properties, such as rental defaults.
Special risks associated with investments in commodities include market price fluctuations, regulatory changes, interest rate changes, credit risk, economic changes and the impact of adverse political or financial factors.
Equities
Commonly known as stocks, equities are ownership shares of a publicly traded company. There’s a wide variety of ways to own shares of a company, from publicly traded shares to funds that own stocks — and even investments in privately held companies.
Return: If you own stock in a company and the company appreciates in value, your share of the company is worth more, too. Returns can come in two ways: appreciation and dividend payments. Both are driven by the company’s earnings.
Risk: It’s possible to lose money with equities, including the principal investment. Equity securities are subject to stock market fluctuations that occur in response to economic and business developments.
A diversified investment portfolio generally contains a mix of asset classes. Which asset classes you include in your portfolio, and how heavily you invest in each, should depend on your financial goals, your age and the level of risk you’re comfortable with.
Alternative asset classes: definition, benefits and risks
Investors are increasingly interested in alternative investments when looking to diversify their portfolios. An alternative investment is an investment that doesn’t fall into a conventional investment category like those listed above. Alternatives tend to be more complex investments and can, in many cases, move counter to stock or bond markets. This may make them an effective portfolio diversification tool.
Alternative investments can sometimes carry higher risk due to the types of investments included in their portfolios. Additionally, most alternative investments require potential investors to meet strict standards to invest.
Read more about the benefits, risks and types of alternative investments.
Asset class investing via ETFs and mutual funds
A diversified investment portfolio generally contains a mix of asset classes. Which asset classes you include in your portfolio, and how heavily you invest in each, should depend on your financial goals, your age and the level of risk you’re comfortable with.
Exchange traded funds (ETFs) and mutual funds are one way to invest in asset classes. These are professionally managed funds designed to give investors diversified exposure to a particular segment of the market without having to buy and sell hundreds of different securities. Both ETFs and mutual funds invest in what’s typically referred to as a “basket of securities” comprised of stocks and/or bonds.
The differences between ETFs and mutual funds start with how they’re built and traded.
ETFs: Even though they contain a basket of securities, ETFs are traded like a single security on a major U.S. stock exchange. ETFs can be bought and sold intra-day, just like any security. Most ETFs are passively managed, which means they’re designed to automatically track a market index.
Mutual funds: Mutual funds are priced and traded at the end of each trading day based on the fund’s net asset value (NAV). This provides investors with less flexibility in timing and price. Whereas most ETFs are passively managed, most mutual funds are actively managed, with the goal of outperforming a market index.
ETFs are usually less expensive and more tax efficient than mutual funds, since there is less turnover in securities and lower trading costs. However, ETFs forgo the opportunity to manage risk or return relative to the benchmark they track.
Your investing goals and objectives will determine which type of investment is right for you.
Learn more about asset classes
Learn more about how a diversification strategy can help your investment portfolio.
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