What Are Asset Classes?
The first step to understanding the world of investing is having a grasp on the major asset classes. Asset classes are used to categorize financial investments into loose groupings based on shared characteristics, general market behavior, and the way they’re regulated. Once you have a basic knowledge of the investment categories available to you, you’re well on your way to knowing what kind of investor you want to be!
Asset classes are generally broad and designed to group a wide variety of financial instruments into manageable categories. Some of the most common examples are equities (stocks), fixed income (bonds), real estate, commodities, forex (currency exchange), and now cryptocurrencies. Instruments within each class often relate based on the actual product (Google and Facebook stock are in the same class), but asset classes are also categorized based on the investment’s risk level and expected behavior in any given market environment.
Below, we’ll walk through a brief explanation of each major asset class of investments. While you’ll probably identify a few that make the most sense for your investing style, keep in mind it’s important to have a diversified portfolio, so you’ll want to have a basic understanding of all of them!
Let’s start with the three main asset classes in traditional investing: equities (stocks), fixed income (bonds), and money market instruments (cash equivalents). From there we’ll dive into other different asset classes, like real estate, commodities, and crypto.
For new investors, equities (or stocks) are a great place you’ll start. Put simply, equity refers to owning shares of a company. In order to raise cash capital, companies will sell a percentage of ownership in the company either directly to an investor, or openly to the general public in an IPO, through stocks. When investors buy stock in the stock market, they’re buying a piece of ownership in a company.
So how do you make money from equity investments? When you invest in a company, you earn a return on the stocks you’ve bought if that company pays dividends or, more commonly, when the value of the ownership of stocks you purchased increases and you sell the stocks for more than what you originally paid.
Stock investing is a great place to start for novice investors for lots of reasons. Most of all, there’s something for everybody. You may not understand the stock market or investing in general, but you probably have some companies you have a lot of faith in, or products you predict will take over a market. Maybe you work in a field that gives you insight into a particular market and you can use your personal knowledge to inform your investing decisions. Or maybe you tried a new product that changed your life and you see a bright future for the brand.
Another appealing aspect with equity investing is it’s fun! You may find yourself watching CNBC with the same dedication you give to sports. Of course, as with any investment, there is risk involved – the stock market can be volatile, and some companies just don’t live up to market expectations. But, once you have some skin in the game, market analysis becomes much more exciting!
Fixed Income (Bonds)
A fixed income investment is one that pays a set amount of money over a given period of time. The most common fixed income investments are bonds, which can be either corporate or government bonds. When you buy a fixed income asset, you are essentially lending money to an entity which is paid back over time with interest. Investors receive payments in a fixed amount until the maturity date, when the initial loan is returned to the investor.
Fixed income investments come in a wide variety of risk and return options. For example, most bonds come from either the government or private companies. The risk in buying bonds is based on the likelihood that the entity you invested with can eventually repay the loan. So, it stands to reason that government bonds are less risky than corporate bonds – the chances of an entire state going broke is low, and thus the income you earn through interest is low. Conversely, because companies can go bankrupt, corporate bonds often carry more risk, while offering higher returns in interest income to investors.
Essentially, fixed income investments are loans that you collect interest on. Think of it as loaning money to your friends – you may charge less interest to a reliable friend, with lots of confidence they’ll return the money quickly. But we all have those friends who may not inspire the same confidence, in which case you’d ask for more interest on any money you loaned them. At the end of the day, higher risk means higher potential reward when it comes to fixed income investing.
A commodity is a raw material that can be transformed into another good, product, or service. The most common commodities for investors are based in goods like steel, oil, energy resources, or agriculture products. These raw materials can change in value based on world events, and your returns are based on supply and demand rather than profitability.
Commodity investing can be a little confusing, simply because there are so many ways to invest in commodities. Of course, you can buy equity (stock) in a company that produces these raw materials. This is actually one of the most common methods of commodity investing. However, we still classify it separately from equity investing because of the way these assets behave in the market, based on supply and demand.
Put it this way, commodities are vital to the world economy, while individual companies come and go, and few, if any, are truly crucial to a functioning market. You shouldn’t evaluate investing in steel the same way you would investing in Facebook. In a diversified portfolio, commodities are also often thought of as a way to hedge, or balance, the risk of equity or fixed income investing in products or brands.
So how do you buy commodities? Without getting into too much complicated detail, you have a few main options. You could always literally buy the raw material with the intention to eventually sell it for a higher price than you paid, but that’s not reasonable for most investors. As mentioned, you can simply buy equity shares of a company that produces the raw material. But commodities also can be invested in through Exchange-Traded Funds (ETFs), which operate in a similar way to mutual funds and are purchased like stocks. ETFs are the most common way individual investors get into the commodities market.
Cash + Cash Equivalent Investing
This one is simple, and you’re probably already doing it to some degree. You’re investing in cash itself, so the risk is extremely low, but so is the potential return. Investing in cash sounds complicated but it’s not, if you have money in a savings account collecting interest, that’s cash investing. Congratulations, you’re an investor!
Cash and cash equivalent investing also includes government treasury bills, guaranteed investment certificates (GICs), and money market funds. Yes, leaving your money in a savings account to collect interest is low risk, but it’s not completely risk-free.
Forex refers to the exchange of foreign currencies as an investment instrument. This is the process of trading one currency for another, like you would for an overseas vacation, but for profit rather than spending money. Forex investing is a huge market, with daily trading volume reaching $7.5 trillion a day in 2022.Unlike equity investing, the foreign exchange market has neither a centralized marketplace, or standard trading hours. This results in a highly dynamic market, with foreign exchange prices changing all day, every day, making it the only real 24/7 trading market. The internet has opened this market up to individual investors, but it’s usually conducted by banks or larger entities on behalf of their clients.
The best advice anyone can give about investing is to diversify your portfolio – never put all your eggs in one basket. For all the energy you put into stock market analysis and day trading, you shouldn’t neglect the most obvious forms of investing, even if they’re less exciting. Real estate investments have been around long before the stock market itself, and at some point in their lives, most people become real estate investors.
For simplicity’s sake, let’s take real estate as an example for a whole world of investing. Whether it’s a house, office building, or land, you’re buying property with the hope that it will gain value over time and you can sell it for more than you paid. This approach applies to art, valuable cars, or that rare Star Wars action figure that’s still in its original packaging.
This type of investing can be much more palatable to people without a finance background, especially if you’re a car aficionado or a real estate agent. For this asset class, just your life experience can sometimes be enough to inform smart investments. You think a neighborhood is on the rise, so you buy a house there and hope it’s worth more when you go to sell years down the road.
The drawback here comes with the “years down the road” part… it’s a slow process. Smart real estate investing can provide huge returns, but it usually takes a long time for the value to increase substantially. These alternative asset classes are also far less liquid than equities and bonds.
Here’s where things get a bit harder to grasp for novice investors. In order to understand futures, first we have to understand what a derivative is. A derivative is a financial contract between two or more parties revolving around an underlying asset or assets, based on speculation on the market behavior of said asset. This contract revolves around an asset class – if x asset does y, we agree to do z with the asset, like sell or buy, and is generally used to hedge or manage risk.
Futures are a specific type of derivative contract in which the parties commit to buy or sell an asset at a specific date and price in the future. The agreed upon price and date must be fulfilled despite anything going on in the current market. There is a designated futures exchange in which these derivative contracts are traded, and they’re most often used to speculate on price variation and hedge investments, mitigating losses if the value of the asset drops. In practice, futures contracts often involve taking the opposite position you’ve taken on the asset itself, so that if your asset investment loses money, the future covers some of the loss.
So yeah, they’re complicated for new investors…
Crypto is very much the new kid on the block when it comes to asset classes. Unless you’ve completely ignored the news for the last five years, you know it’s been a wild ride for crypto investors. Crypto is still extremely volatile and underregulated, but in practice it’s a similar concept to foreign currency exchange. Investors buy and trade cryptocurrency “coins” as their value fluctuates, seeking to sell for more than they bought any given cryptocurrency.
As it stands, crypto investing certainly comes with the highest risk of any asset class. While high risk typically signals high return, cryptocurrency is still an unproven asset. Unlike gold or government currency, its value can be anything, even zero. The fact that crypto is so unregulated makes the risks even more extreme.
What makes cryptocurrency investing so appealing, especially to novice investors, is the open frontiers the asset class provides. There’s really no telling how valuable these currencies could become. The wild speculation attracts lots of media attention (and penalized celebrity endorsements), enticing lots of people to make uninformed investments. And yet even the most experienced financial advisors can’t predict where this market is going. We get it – it’s fun and exciting, and we don’t want to discourage it outright, but it’s important that new investors grasp the risk involved with cryptocurrency investing.
Non-Fungible Tokens (NFTs)
While we’re talking about alternative investments and new asset classes, let’s not leave out NFTs. Like crypto, NFT investing is another wild west investment market that makes daily headlines and attracts lots of first-timers to the investing marketplace. You can think of them the same way you would real estate investments – hoping they gain value over the course of your ownership. The difference lies in the blockchain and physical existence itself.
That’s right, they don’t exist, at least in the physical sense. NFTs are digital assets that are individualized through a blockchain, adding unique codes and metadata to allow individual ownership. For example, a funny meme can be assigned a unique code and sold, so that one person owns the digital asset that is said meme. Is there value there? Some people believe strongly yes, others will continue to share that meme without giving any thought to its ownership on the blockchain. We’ll have to see where this asset class goes in the future, but if you’re one of the ones who sees the value, there’s a whole metaverse out there for you to explore!
Which Asset Classes Are Most Popular?
Real estate (or buying anything you hope will increase in value over time) may be the oldest, and crypto and NFTs are certainly the latest alternative investments, but the most common asset class utilized by investors is classic stock market equity investing. If you’re thinking about investing, you’re probably already a cash equivalent investor (you do have a savings account, right?)
Equities investing is so appealing because everyone can do it, even without having a ton of money to put into your investment portfolio. Life experience can inspire shrewd investment decisions in the stock market, and it’s fun to win with a brand or company you love. Fixed income or bond investing is also a popular asset class, while futures are often too complicated for novice investors and crypto investing isn’t for the faint of heart. At the end of the day, the most financially sound approach to asset allocation lies in diversification – spread your bets over a variety of different asset classes to mitigate risk.
Which Asset Class is the Most Rewarding?
Well, a good financial advisor would probably say a varied portfolio including a little bit of everything is the right move. But some asset classes are historically more rewarding over a long period of time, while others are better for short-term returns. $500 invested in the stock market a century ago would be worth exponentially more today than $500 invested in government bonds, and unthinkably more valuable than had it been sitting in a savings account collecting minimal interest. The risks, returns, timelines, and barriers to entry vary wildly between asset classes, but investing is personal and diversification is crucial.
Whether you’re investing alone, or getting qualified financial advice, understanding how each investment type is classified is important just to comprehend the trades you’re making or the advice you’re getting. But, if you’re a first-time investor navigating the market on your own, you may find some of these asset classes intimidating or still hard to understand. To build a truly diversified investment portfolio, with a variety of different asset classes, you work with the Experts!
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