What are Asset Classes?
There’s a broad range of different assets out there you can invest in. And while they’re largely different, many of them fall into specific asset classes. An asset class is a category or grouping of investments. Some examples are equities, fixed income (e.g., bonds), and real estate. These assets get lumped together because they share many of the same traits and behave similarly.
Many investors form investment theses or find themselves attracted to different asset classes because of their shared similarities, how they behave in the market or even their risk tolerance. Asset classes play into everything from asset allocation to rate of return and volatility. Here’s what you need to know about them to invest in one (or many) with confidence.
The Big Three Asset Classes
In the investment world, there are three major asset classes: equities, fixed income (bonds) and cash. These are the most basic, fundamental asset classes, which also makes them the most accessible.
- Equities include stocks, index funds, ETFs and similar securities.
- Fixed-income includes corporate bonds, treasuries and other debt securities.
- Cash can include money markets and other cash equivalents.
These asset classes also represent the gamut of risk, as well. Most portfolios will include an allocation to all three. Aggressive allocations will weigh heavily in favor of stocks; more conservative allocations favor bonds.
Other Major Asset Classes
Beyond the “big three,” there are several other major asset classes to consider. These assets aren’t as accessible or as equities, fixed-income or cash, but there are nonetheless robust markets for them.
- Property includes everything from rental properties to undeveloped land holdings.
- Commodities include precious metals, oils and other staples.
- Derivatives represent contracts with values relative to underlying assets.
- Cryptocurrency includes blockchain-backed tokens, altcoins and even NFTs.
- Collectables are any item with value based on what someone else is willing to pay.
These asset classes represent even more ways to diversify a portfolio and hedge against risk. That said, they tend to be less liquid than the core asset classes. For example, it’s easier to sell stock and benefit from capital gains than it is to sell a house and extract its equity.
What Constitutes an Asset Class?
Why do Microsoft (Nasdaq: MSFT), the iShares Robotics and Artificial Intelligence ETF (IRBO) and the Russell 2000 Index (RUT) all belong to the same asset class? Why don’t U.S. 10-Year Treasury Notes belong in this asset class?
The rules behind what constitutes an asset class have to do with how the assets within them behave. There’s also consideration to how they’re taxed. Individual stocks may go up and down independent of each other, but they’re still beholden to the rules of the stock market. Likewise, all bonds function similarly, paying fixed rates for a predetermined term. These governing factors are what delineate different assets—and attract different investors.
What are Asset Classes Used For?
Look at your portfolio. What is your asset class breakdown? This is the total percentage of the portfolio devoted to a particular asset class. This breakdown represents your asset allocation, which can clue you in to everything from risk potential to portfolio performance.
Most investors use asset classes for the purpose of allocation. Because each asset class carries its own level of volatility, allocating with that in mind helps investors manage their overall risk tolerance. For example, if you’re a 20-something new investor with a long time horizon in front of you and a high tolerance for risk, equities are a no-brainer. If you’re 60 years old and nearing retirement, fixed-income investments offer a more appealing proposition because they’re low risk.
Outside of diversification, asset classes also help investors identify opportunities. For example, if the stock market is in a bear market, it means equities are likely undervalued. This presents an opportunity that might not be present in the fixed-income market. Asset classes make it easier to comb through potential investments based on current market behaviors and investor sentiment.
What are Asset Sub-Classes?
If you want to get granular, each asset class has asset sub-classes. They’re nested types of asset classes that fall within the broader class. For example, stocks are equities and within this asset class there are growth stocks and dividend stocks. These subclasses give investors even more control over how they invest. You might choose dividend stocks if you want a less volatile equity investment, which is aggressive by nature. Likewise, you might have the risk tolerance to take on a low-grade bond with a much higher yield. Sub-classes offer nearly infinite potential for tooling a portfolio.
What’s the Best Asset Class?
Asset classes are subjective based on risk tolerance and performance. Historically speaking, however, equities are far and away the most lucrative asset class. This is because of the compounding power of equities—and the fact that they’re widely accessible to a majority of investors. Since 1920, the stock market has had an annualized return of 7.6% (adjusted for inflation). This outstrips most other asset classes by a wide margin.
The “best asset class” is the one you understand. Investors should be intimately familiar with any asset class they’re interested in, to understand how it behaves and the nuances of holding these assets. Acute understanding of assets enables you to maximize them.
Get Familiar With Asset Classes
Investors will gravitate toward different asset classes based on their investment preferences. If you embrace risk, bonds may seem like a bore compared to growth stocks. If you’re getting on in years and want to be defensive, fixed-income assets are a welcome investment.
And you can enhance your profits with a wide range of assets. Therefore, sign up for the Profit Trends e-letter below and find the next big investment opportunity for you. The more you know about the major asset classes and their subclasses, the more empowered you’ll be in allocating your wealth in a risk-tolerant portfolio.