Many different asset classes are available to investors. Therefore, it is possible to build a diversified asset allocation by combining them. In this guide, we describe the most important asset classes and their main characteristics.
- Treasury Bonds
- Corporate Bonds
- Cash and Currencies
- Investment Funds
- Exchange-Traded Funds
- Real Estate
- Private Equity
Even though most investors are only familiar with a handful of asset classes, namely cash, stocks and real estate, capital markets make it possible for us to invest our money in many other places.
The goal of this guide is to provide you with a complete overview of all the most important asset classes available. With this introductory information, you will be able to find additional resources that will allow you to expand your knowledge in those are that are most appealing to you.
You will also be in a position to design the asset allocation that works best for you given your personal circumstances, risk appetite and investment horizon.
Investing goes way beyond deciding whether you should put your savings in the stock market. While interesting, the stock market is only one many places where our capital can be put to work.
Equities, also known as stocks, are one of the most popular asset classes. They also receive a lot of attention from the press. Whenever we hear about the financial situation of a country, the stock market is referenced in one way or another.
Stocks are shares of publicly traded companies. While most multinational companies are traded on the stock market and are available for us to buy, plenty of smaller companies with less internationalized businesses are also listed.
Investing in stocks entitles us to benefit from the profits that a company generates. These profits can be in the form of dividends paid to shareholders or higher stock prices. Additionally, because companies are able to grow, we can benefit from that.
Of course, companies can also lose money or see their business shrink. This is why stock investors can experience losses, especially in times of economic and financial distress.
Owning stocks means we have a partial ownership of those companies, and we get to vote on important decisions.
The financial press often mentions equity indices to talk about the state of the stock market. Indices are baskets of stocks whose performance is indicative of what is happening in a particular stock market. For example, the performance of the S&P 500 is often used to describe how the US stock market is doing.
2) Treasury Bonds
Treasury bonds, also known as sovereign bonds, are debt instruments issued by governments. Because governments are highly indebted, treasury bonds represent the largest financial market.
Bonds allow us to receive interest payments on a regular basis and get our money back at a predetermined date. Of course, we can also sell our bonds if we do not want to wait until they mature.
Because bonds can be bought and sold at any time, their prices fluctuate constantly. Even though they are less risky than stocks, we can also experience significant gains or losses by investing in bonds.
Bonds issued by countries such as the United States, Germany or Switzerland are considered free of credit risk. Those issued by countries such as Italy, Spain or Mexico are exposed to credit risk.
3) Corporate Bonds
Corporate bonds are debt securities issued by companies. They share many things with sovereign bonds. Corporate bonds also entitle us to receive regular interest payments, known as coupons, and receive our money back when they mature. They can be bought and sold at any time.
Corporate bonds have higher credit risk than treasury bonds. This is because companies are more exposed to the risk of default. As a result, they usually pay a higher interest rate. Corporate bond prices can fluctuate wildly at time.
The credit markets are very heterogeneous. Consequently, we can find companies with balance sheets that are more robust than many governments, and companies on the brink of bankruptcy. The safer the bond, the lower the interest rate we will receive, but the lesser the risk.
Commodities are natural resources. The commodities market allows us to invest in things like oil, aluminum or coffee. Commodities can be interesting because their prices are usually correlated with inflation. This is because commodities prices are an input to inflation.
If we are afraid that the cost of living may rise in the future, invest in commodities can be a good way to hedge that risk.
The commodities market trades in the form of futures contracts. Due to their complexity, most investors interested in investing in commodities prefer to buy into a commodities ETF or even stocks of commodity producing companies.
Generally considered a commodity, gold plays a special role in the financial markets. Unlike other precious metals such as platinum or palladium, gold has little industrial use and is usually considered an alternative form of money. It is a safe haven asset.
Gold has been used as money throughout much of history. Unlike money created by humans, like US Dollars, Euros or Pounds Sterling, the amount of gold in the world is limited. In fact, until 1971, most currencies in the world were backed, directly or indirectly, by gold.
Although the value of fiat currencies is no longer tied to gold, the yellow metal still plays a key role in the monetary system. The largest holders of gold around the world are central banks. Owning gold gives credibility and stability to a country’s institutions.
For all these reasons, gold is usually the preferred asset class in times of geopolitical, economic and monetary turmoil. The outlook for the 2020s makes gold a very interesting asset to own.
6) Cash and Currencies
Cash or currencies are forms of money created by government institutions: US Dollars, Euros, Japanese Yen, Pounds Sterling, Mexican Pesos, Swiss Francs, etc. They can be bought and sold at any time and their prices fluctuate against one another.
Keeping cash in our portfolio is a good way to earn some interest on our money and derisk our investments. If that cash is denominated in our foreign currency, its nominal value should not move at all. Therefore, cash is a form of dry powder that can be deployed if there is a crash in the markets.
On the other hand, owning foreign currencies allows us to benefit from movements in the FX market, receive interest in other currencies, and further diversify the risk of our portfolio. The US Dollar, the Swiss Franc and the Japanese Yen tend to strengthen in time of financial distress.
7) Investment Funds
Investment funds, also known as mutual funds, do not represent an asset class per se but are simply a vehicle through which we can invest in other asset classes. For this reason, there are many different types of investment funds.
Funds can invest in stocks, bonds, commodities, precious metals, currencies, a combination of all those things, and other alternative asset classes.
Due to the wide range of funds available in the market, we can choose them based on the assets they, or the countries and sectors they focus on. Because they are managed by an asset management company, we will be charged a regular management fee which will be a percentage of our investment.
We can invest in a fund by transferring money to an asset manager. If we want to exit our investment, we will give notice to the fund manager and, in most cases, our position will be liquidated by the end of that day.
8) Exchange-Traded Funds
Exchange-traded funds, commonly referred to as ETFs, are very popular nowadays. They many similarities with traditional investment funds and offer us the option to invest in different asset classes: stocks, bonds, commodities, etc. Despite those similarities, there are some important differences between ETFs and mutual funds.
ETFs are usually passively managed. This means they are managed to track an existing stock or bond index, without analyzing individual assets to choose the more attractive one. Thanks to this, ETF management fees tend to be much lower. And their performance before commissions is usually as good as that of mutual funds.
Another difference is that we can buy and sell ETFs at any time if the stock market is open. In fact, ETFs can be traded the same way we would with a stock.
9) Real Estate
Real estate is the largest asset class in the world, though most of it is not traded on the financial markets. Real estate consists of developing or owning apartments, houses, office space, parking space, and other commercial facilities with the goal of renting them out, generating a recurring income stream, and seeking long-term appreciation.
We can also own undeveloped land with the sole purpose of capital appreciation.
Real estate investing offers us the possibility to find good investment opportunities and improve the quality of the assets we buy. Additionally, we can use mortgage debt to finance a significant portion of the purchase.
Certain real estate assets can be invested in through the stock market. REITs (real estate investment trusts) own hundreds or thousands of real estate units, leading them out and generating income for their shareholders. They trade on exchanges just like any stock or ETF.
Because real estate represents real physical assets, it is one of the asset classes that performs best in times of long and elevated inflation.
10) Private Equity
Private Equity funds invest in private or unlisted companies. Their goal is to find good businesses, help them improve their operations, and sell them later at a higher valuation, potentially when the company is listed on the stock market.
Some private equity funds invest exclusively in companies with high growth potential, particularly in sectors like technology.
Because private equity funds own smaller and less consolidated companies, this asset class is generally riskier than investing in publicly listed stocks. At the same time, potential returns are also higher.
Two disadvantages of private equity funds are that they are less liquid, potentially locking our money away for a period of several years and carry higher management fees.
Cryptocurrencies like Bitcoin and Ethereum are digital currencies created by private individuals. Unlike traditional fiat currencies, cryptocurrencies are not controlled by governments or central banks and most of them have a limited supply.
One of the arguments in favor of cryptocurrencies is that their value cannot be manipulated by government officials. This is in contrast to traditional currencies which can be created out of thin air, leading to debasement and high inflation. Some cryptos also offer attractive privacy feature for their users.
Though they have very strong upside potential, cryptocurrencies should be regarded as a speculative asset class, prone to regular crashes. Therefore, it is advisable to be cautious when investing in them.
I hope you found this guide to the most popular asset classes useful and realized that there is much more to investing than just buying stocks or real estate.
The next step I would recommend is to deepen your knowledge about them. You can focus first on the asset classes that appeal most to you. The following menu is a good place to start:
It is also important to remember the role that diversification plays in an investment portfolio.
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