What is an Asset Class?

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Definition:

An asset class is a category of investments that have similar characteristics.

🤔 Understanding an asset class

There are many different types of investments into which someone can invest their money. Analysts generally group together similar investments into a single asset class. An asset class is a group of investments that all behave alike in the market and have similar characteristics. Common asset classes include stocks, fixed-income securities (those that result in regular interest payments), and cash or cash equivalents. Investment assets are generally grouped together based on behavior, level of risk, and the type of income they provide. There can also be subclasses within each asset class. For example, stock is one type of asset class. But you might also group together stocks from a particular type of company (such as domestic vs foreign stocks).

Example

Suppose Tom was just getting started with investing and wanted to diversify his investment portfolio (put his money into a variety of different types of investments). One easy way for Tom to diversify is to split his money up across different asset classes. Tom puts some of his money in corporate stocks, some in fixed-income securities such as bonds, and the rest into cash and cash equivalents, such as his savings and money market accounts (a type of bank account that invests in certain debt securities).

Takeaway

Asset classes are like food groups…

Health professionals recommend making room in your diet for all of the different food groups, which include fruits, vegetables, grains, and dairy. Including each of these in your meals makes for a well-rounded diet. Just like foods fall into different food groups, investments fall into different asset classes. Investing in a variety of different asset classes can make for a well-rounded investment portfolio.

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What is an asset class?

An asset class is a category of investments grouped together based on similar behavior and characteristics. The primary types of asset classes are stocks, bonds, and cash, but there are other asset classes available to investors as well.

What are the types of asset classes?

There are three primary asset classes: stocks, bonds, and cash.

Stocks (aka equities) refer to ownership in publicly traded companies. When someone buys stock in a company, they’re buying a share of the ownership in that company. Depending on the type of stock someone buys, they might get voting rights at shareholder meetings. They also might receive dividend payments, which is when the company passes some of its profits along to the shareholders.

Bonds are a type of debt security that companies and government entities issue. When an organization issues bonds, they are borrowing money. The people buying the bonds are lending the money. Bonds are often (though not always) fixed-income securities. Over the life of the bond, the issuer might make regular (often twice per year) interest payments to the bondholder. Then, when the bond reaches maturity, the bond’s issuer pays the bondholders back the initial loan amount.

Cash and cash equivalents are investment accounts where you can put your money and receive a modest return. The simplest example of such an account is a bank savings account. An account holder puts money into their savings account. The bank then lends that money to other customers and pays the savings account holder interest. Other types of cash equivalent investments include:

Along with the three primary asset classes, there are also alternative asset classes that an investor might put their money into. Alternative investments include:

  • Private equity: A type of investment where individuals invest in and buy shares in private companies.
  • Hedge funds: A type of exclusive investment fund available to organizations and individuals with high net worths.
  • Commodities: Physical assets with financial value, such as gold or oil.
  • Real estate: Physical property such as homes, apartment buildings, business storefronts, and land.

How do the asset classes compare according to risk?

Anytime someone invests their money, they take on some level of inherent risk. But it’s also the case that some investments are riskier than others. In general, stocks tend to be the riskiest investment (of the three primary asset classes). Stock market returns can be volatile, especially in the case of short-term investments. In fact, large company stocks have historically lost money one out of three years.

Bonds result in less risk than stocks, but more risk than investing cash or cash equivalents. Even within this asset class, there are different levels of risk. For example, bonds issued by the U.S. Treasury Department carry almost no risk. And when extremely creditworthy companies issue investment-grade (high credit rated) bonds, the risk is quite low. On the other hand, junk bonds (those with a low credit rating), might be a bit riskier for the investor.

Finally, cash and cash equivalents have the lowest risk of the three primary asset classes. An investor’s chances of losing money on such an investment are very low. In fact, the Federal Deposit Insurance Corporation insures deposits in many of these accounts. Investments with FDIC insurance include interest-bearing savings accounts, money market deposit accounts, and certificates of deposit.

It’s important to note that while stocks, bonds, and cash equivalents are the three primary asset classes, they aren’t the only ones. Other classes such as real estate, commodities, and private equity each carry a level of risk unique to the situation. Investors should be aware of those risks before investing.

What are the returns for each asset for an investment portfolio?

In general, there tends to be a correlation between risk and reward. In other words, those investments that come with a greater level of risk also tend to provide the potential for the greatest return for the investor.

Take a look at the three primary asset classes: stocks, bonds, and cash or cash equivalents. Of those categories of assets, stocks tend to provide the highest total returns mainly made up of appreciation. People are willing to take on the risk that comes with stocks because of the (typically) higher average returns. Of course, historical performance is not predictive of future returns. All investments carry risk. Always keep investment objectives in mind.

Bonds, which tend to be less risky than stocks for investors, also tend to have a lower average return which is made up of more dividends. But even within bonds, there are different levels of return an investor can get. Because of their risk, junk bonds tend to provide a higher yield than those from more creditworthy companies; this is, however, to be balanced against the higher risk of default on these bonds.

Finally, cash and cash equivalents have the lowest financial return of the primary asset classes. Your chances of the investment going south are very low. However, one’s returns might not keep up with inflation (the rise in the price of goods and services over time).

Between January 2000 and December 2019, the United States saw an average inflation rate of 2.165% and a cumulative inflation rate of 43.3%. If someone had put their money into a cash equivalent investment with a lower return than that, they would have actually lost money in real-dollar terms.

How should someone invest in asset classes?

There’s no one right way for everyone to invest. But a diversified portfolio can help reduce an investor’s risk level, while also providing them with return potential. Diversification refers to the variety of investments in someone’s portfolio. Generally speaking, the more different types of investments in which someone invests, the more diversified their portfolio is.

Diversification happens in two ways: across asset classes and within asset classes. First, an investor can diversify by spreading their money out across the different asset classes. To do this, they’d put some of their money in stocks, some in bonds, and other money in cash or cash equivalents. They also might invest in alternative investments such as real estate or private equity. Investing in different asset classes is intended to help avoid having a whole portfolio taking a hit instead of just one asset class going south.

For example, suppose an investor had put all of their money in the stock market in early 2020, before the stock market fell 36%. They probably would have seen their stock portfolio go down quite a bit. But if they also had money in bonds, they probably wouldn’t have seen the same hit there, since bonds are fixed-income investments.

The other type of diversification is within asset classes. For example, someone might put some money into investment-grade (highly-rated) bonds and some money into junk (low-rated) bonds. The junk bonds are riskier, but have a higher return. But if a junk bond goes south, the investor hopefully still has some income from the investment-grade bonds.

It’s important to note that diversifying one’s portfolio is in no way a guarantee against financial losses. It’s still possible for a diversified portfolio to perform poorly. The hope is that it will help to make the losses less severe.

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The free stock offer is available to new users only, subject to the terms and conditions at rbnhd.co/freestock. Free stock chosen randomly from the program’s inventory. Securities trading is offered through Robinhood Financial LLC.

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