What are Asset Classes and Why Should I Know About Them?
Asset classes, or asset categories, are essential layers of the investment world. Put simply, an asset class is a specific kind of investment opportunity, each with its own level of risk and expected return associated with it. Knowing the differences between each asset class can be the key to making informed and profitable decisions when it comes to investing.
One of the most important – but often underestimated – aspects of investing is diversification. This is the practice of selecting and investing in different kinds of asset classes, so that your portfolio is not overly weighted to one or two areas of the market. A diversified portfolio will not only give you greater potential returns, but also offers protection against the possibility of significant losses if one or two sectors of the market perform poorly.
So what are the six key asset classes?
1. Cash and Cash Equivalents: Cash and cash equivalents are short-term investments such as bank deposits, short-term certificates of deposit, and money market funds. These are very liquid investments, offering convenient access to cash in the event of an emergency. They are also low-risk investments since their principal amounts are generally guaranteed, but they offer few opportunities for significant returns.
2. Fixed Income Securities: Fixed income securities are investments with specific maturities and frequent, steady cash flows. Examples include government bonds, corporate bonds, and mortgage-backed securities. These investments have a low level of risk, but offer significantly lower returns than other asset classes.
3. Equity Securities: Equity securities are investments in company stock. As a shareholder, you are a part-owner of the company, and your profits will depend on the performance of the stock. Equity securities offer the potential for significant returns, but they also come with considerably higher levels of risk.
4. Commodities: Commodities are basic forms of money, such as gold, silver, oil, and wheat. These assets have been historically used as currency, so the prices tend to fluctuate in response to macroeconomic events. As they are generally considered to be more speculative investments, they are higher risk and are typically used to diversify portfolios.
5. Real Estate: Real estate encompasses both residential and commercial properties. The prices of these assets are sensitive to economic events, and so offer an opportunity for higher returns but with a much greater level of risk.
6. Alternative Investments: This category includes instruments such as venture capital, private equity, hedge funds, and derivatives. As these investments are typically specialized and not very liquid, they are for those who have the knowledge and experience to evaluate an asset’s true value, and the stomach for potentially large profits or losses.
As you can see, it is important to understand the difference between each asset class and the level of risk associated with it. With this knowledge, you can properly construct a portfolio that meets your investment goals, while minimising overall risk. Additionally, some assets such as real estate and alternative investments can be used to increase potential returns, but they should only be approached after doing your due diligence.