Investing in a variety of asset classes can be an important strategy for investors who may be looking to build or diversify their portfolio. However, investors may not know what types of investment asset classes exist. What are the four common kinds of asset classes and why can diversification and asset allocation be helpful for investors?

Investment Asset Classes

Understanding Different Asset Classes

What is an Asset Class?

An asset class is a group of investments based on shared behaviors, characteristics, and regulations. There typically is very little correlation and sometimes a negative correlation among different asset classes.[1] There are four common kinds of asset classes – cash, equities, fixed income, and alternative investments.[2]

Cash and Cash Equivalents

The first kind of asset class is cash or cash equivalents. This can be the most straightforward because it is the legal tender used to buy goods and pay debts. On the other hand, cash equivalents are investments that can be easily converted into cash. Examples of this include some types of money market funds and U.S. Treasury bills.

One risk when investing in cash equivalents is that the issuer may not be able to pay the debt at maturity. Before investing in cash equivalents, investors can research the characteristics of the issuing company, its business climate, and the economy.

Equities

The next asset class is equities. Equities are shares of ownership in a company, more commonly referred to as stock. The value of equities can either rise or fall based on the company’s performance, investor demand, or other factors. There are usually two ways to make money from investing in equities: (1) if the company pays a dividend, or (2) if you sell the shares for more than you paid for them.[3]

If investors own stock in a company and the company appreciates in value, the investor’s share of the company can be worth more too. However, it is still possible to lose money with equities, including the principal investment. Equity securities are subject to stock market fluctuations that can occur in response to economic and business developments.

Fixed Income

The third kind of asset class is fixed income. Fixed-income securities are loans that are split into units and sold to investors. Investors provide the principal upfront and receive interest payments until the security matures. At maturity, investors are repaid the principal. Fixed-income securities may provide regular income, but it is not guaranteed. An example of this would be a bond.

Investments in fixed-income securities are also subject to various risks, including changes in interest rates. The risk may be greater for longer-term securities. Credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, and tax consequences are other risks.[4]

Alternative Investments

Finally, an alternative investment is an asset class that some other kinds of investment falls into if it does not fall into the other three classes mentioned above. Alternative investments can include startups, real estate, precious metals, and cryptocurrency. These are just some examples, not an exclusive list of alternative investments, and you can learn more about them here.

Alternative investments are inherently risky due to the illiquidity of the assets and the amount of time that it could take to find a buyer to convert the asset to cash. Investments in real estate can be subject to fluctuations in property values, the effect of economic conditions on real estate values, changes in interest rates, and risks related to renting properties. Additionally, investments in cryptocurrency can also be risky due to its volatility in an ever-evolving market. Finally, the price of precious metals can drop due to imbalances, making investments risky as well.

Diversification within Asset Classes

Diversification is the spreading of your investments both among and within different asset classes. It can help mitigate the risk of losses that can result from overemphasizing a single security or asset class. This can be especially true if your assets are “uncorrelated,” meaning they react to economic events in ways independent of other assets in your portfolio. However, it is still important to remember that even through diversification, there is always still risk and a chance for investors to lose their total investment.

Stocks and bonds, for instance, often move in different directions from each other, which is why holding both asset classes (and others) may be able to help mitigate risk.

How to Diversify

According to FINRA, financial experts tend to recommend diversification among and within asset classes.[5] For example, diversification increases when an investor owns multiple stocks and can be further increased when the stocks are made up of different-sized companies, include different sectors, and are diversified geographically.

Additionally, investing in each class – cash, equities, fixed income, and alternative investments – may be beneficial for investors when looking to diversify their portfolio. Investors can choose to invest different amounts within different classes depending on what they believe their risk tolerance is and how much capital they have available.

Why Asset Allocation can be Important

Helping to mitigate investment portfolio risk by diversifying your investments across different asset classes is commonly referred to as asset allocation.[6] Historically, the returns of three major asset categories have not moved up and down at the same time.[7] Market conditions that typically cause one asset class to do well generally may cause another asset class to have average or poor returns.

By investing in more than one asset class, if one asset category’s investment return falls, the investor may be able to counteract your losses in that asset category with better outcomes in another asset category.[8] Please remember past performance is no guarantee of future results even if assets are allocated to different asset classes.

Final Thoughts

In conclusion, understanding asset classes and how to allocate investments across different asset classes can help investors make informed investment decisions. By diversifying across multiple asset classes and properly allocating assets, investors may be able to mitigate the associated risks with investing.

While no investment strategy is foolproof, understanding the unique characteristics of cash, equities, fixed income, and alternative investments can empower investors to make informed decisions that align with their financial goals. It still may be beneficial to contact a financial advisor to review your personal situation and available options before making any investment decisions.

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[1] https://www.investopedia.com/terms/a/assetclasses.asp

[2] https://www.fool.com/terms/a/asset-classes/

[3] https://www.investopedia.com/terms/a/assetclasses.asp

[4] https://www.usbank.com/financialiq/invest-your-money/investment-strategies/asset-classes-demystified.html

[5] https://www.finra.org/investors/investing/investing-basics/asset-allocation-diversification

[6] https://corporatefinanceinstitute.com/resources/wealth-management/asset-class/

[7] https://www.sec.gov/investor/pubs/tenthingstoconsider.htm

[8] https://www.investor.gov/additional-resources/general-resources/publications-research/info-sheets/beginners-guide-asset

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The information presented here is for general informational purposes only and is not intended to be, nor should it be construed or used as, comprehensive offering documentation for any security, investment, tax or legal advice, a recommendation, or an offer to sell, or a solicitation of an offer to buy, an interest, directly or indirectly, in any company. Investing in both early-stage and later-stage companies carries a high degree of risk. A loss of an investor’s entire investment is possible, and no profit may be realized. Investors should be aware that these types of investments are illiquid and should anticipate holding until an exit occurs.

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