Key takeaways:
- There are four broad groups of asset classes that an investor can consider when developing an investment strategy
- The four asset classes are: equities (i.e., stocks), fixed-income (e.g., bonds, treasury notes), physical assets (e.g., real estate), and cash
- These four asset classes have different risk and reward profiles to consider. Think of an asset class as a bucket of investments that share similarities
- Subclasses of these asset classes exist. Here’s a quick article on subclasses
As you start your investing journey, I’m sure it’s both exciting and frightening. “Where do I start?” is a typical question. Well, a crucial part of any investment strategy is determining which assets to contribute. To make informed decisions about allocating funds, I believe it is critical to understand the main types of investment options (called asset classes). Below is a simplified summary of the different asset classes available to investors.
Here’s a simplified illustration to put things in perspective. More on subclasses can be found here.
Equities (i.e., Stocks)
Equity represents ownership in a company. When you own stock (i.e., equity), you are a shareholder of that company and, thus, own a portion of its profits and value. Equity ownership can be in a private or public company. Public company stock is a common investment and is the focus of this section. Private company stocks, such as investing in a startup, have distinctly different considerations.
Some of the advantages and disadvantages are:
Advantages:
- Stocks have high returns. Historically, stocks have returned the highest returns among other asset classes over the long-term.
- Most of the time, stocks have high liquidity. This characteristic gives investors flexibility in making any desired changes quickly.
- The entry capital commitment is low. It does not take a lot of money to start investing in stocks.
- Stock diversification is relatively easy. The vast selection of stocks across different industries, end-markets, customers, and regions, and the low entry capital commitment make it easy for investors to develop a diversified portfolio.
- Stocks generates income through dividends. An investor can build a portfolio balanced across income and value appreciation with the use of stocks.
Disadvantages:
- Stocks have high short term volatility. The stock market reacts (and sometimes overreacts) to news and events. As seen in the dotcom bubble, the Great Recession, and the impact of COVID-19, the stock market can lose value in the blink of an eye. It is worth noting that volatility can be a friend too.
- On top of high volatility, there are specific company risks. Companies do go bankrupt (e.g., Hertz), and stock value can plummet (Hertz’ stock price dropped from $16.07 on 1/2/2020 to $0.56 on 5/26/2020, a 96.5% decline). Diversification works to mitigate company-specific risks.
- Despite that stocks generate income through dividends, that income is not guaranteed (this is in contrast to interest payments from fixed-income investments, which are guaranteed). Dividends can be reduced or eliminated.
Fixed-income (e.g., bonds)
Fixed-income are investment vehicles that generated a specified rate of return. This is basically a fancy way of saying that fixed-income products pay a fixed interest. For example, a $10,000 bond may specify that it will pay 10% interest annually, which generates $1,000 in income. Bonds, certificates of deposits, notes, and a particular type of preferred securities are common fixed-income investments.
Some of the advantages and disadvantages are:
Advantages:
- Predictable, fixed income generation is one of the main benefits (hence its name). While there is a risk that the issuer (i.e., the entity that pays interest) defaults and not make good on the promise to pay the agreed-upon payment, the regular stream of income could be a crucial component of a financial portfolio.
- Fixed-income investments are generally less volatile than other asset classes. It’s considered one of the safest.
- Depending on the underlying fixed-income investment, there may be tax benefits. For example, interest payments from municipal bonds may be exempt from federal and state income taxes if certain conditions are met.
Disadvantages:
- A high inflationary environment erodes the value of a fixed-income vehicle. Because bonds have a fixed return, bonds’ real return reduces as inflation increases.
- Interest rates more directly impact the value of bonds and fixed-income products than other asset classes.
Physical assets
Real estate and commodities (e.g., precious metals, oil) are the primary components of this asset class. Real estate is a popular investment asset. Another example is gold. Gold has long been considered a top-class defensive investment that protects against rising inflation and fluctuations in the market.
While I group physical and tangible assets into one for simplicity, there are distinct characteristics for the two primary subgroups (i.e., real estate and commodities), as mentioned above.
Some of the advantages and disadvantages of real estate are:
Advantages:
- Real estate is considered to be anti-inflationary. Tangible assets such as real estate are good hedges against general rising prices (i.e., inflation).
- Real estate is the time-tested way to earn recurring income by renting out to tenants. This boosts returns because it adds to the appreciation of the underlying asset.
- There are certain tax advantages with real estate Investments. Whether it is from mortgage interest deduction or having no corporate taxes for REITs, these saving could further increase returns.
Disadvantages:
- Directly owning real estate may result in additional capital and time investments. It takes time and energy to learn about the necessary legal, tax, and financing needs. Also, there may be required repairs and maintenance costs associated with a property.
- Depending on the approach, it can take significant upfront capital. This disadvantage is mitigated with crowdsourcing real estate platforms and publicly traded REITs.
- Liquidity is limited, depending on the investment approach. Owning real estate directly or through a crowdsourcing platform may limit liquidity conversion. REITs are more liquid.
- There are unique risks associated with real estate investments. An investor may be exposed to a particular region, city, and county depending on the investment. An investor could also see volatility from interest rate movements and localized economic weakness. Property-specific risk (i.e., wrong property at the wrong time) is yet another aspect to consider.
Some of the advantages and disadvantages of commodities are:
Advantages:
- Commodity investments provide protection against inflation (e.g., gold). A famous example is how Warren Buffett purchased thousands of tons of silver in the late 1990s.
- Additional diversification and exposure to different value appreciation opportunities are possible with commodity investing. For example, oil prices are generally uncorrelated to the stock market, making oil an excellent diversification tool.
Disadvantages:
- Commodities investing can be tricky due to the structure and instruments used. For example, some oil ETFs invest in oil future contracts and not energy stocks, which results in price movements that may not be as clear to an average investor.
- There’s no income generation from investing in commodities. Unlike other asset classes that provide some income generation from dividends, interests, or rental income, commodities effectively have nothing in this regard.
Cash and cash equivalents
This asset class is simply the money you have in your pocket, checking & savings accounts, and piggybanks. That sounds boring, but cash can be more than just that. There are different global currencies, and these currencies appreciate (or depreciate) relative to each other, creating opportunities.
Some of the advantages and disadvantages are:
Advantages:
- This asset class is the most liquid or accessible. In times of need, cash can meet obligations quickly and directly.
- Cash is considered one of the safest asset classes. It’s the surest way to know that near-term needs will be covered because cash wouldn’t suddenly lose value ahead of purchase.
- Cash is “dry powder” to act on unique opportunities swiftly. Exceptional opportunities appear randomly, and cash serves as the best vehicle to take advantage of those opportunities when they arise.
Disadvantages:
- Low, if not nonexistent, rate of return. In an inflationary environment, the real return on cash can be negative. Said differently, cash may lose value and purchasing power over time because of the meager returns.
- The flip side of its liquidity is that it’s easier to spend. Going over the budget does not help achieve long-term financial goals.
That’s it on a primer for the main asset classes. Each of these asset classes has further subclasses that are worth exploring, including:
- Region. U.S., foreign developed, and foreign emerging
- Market capitalization (i.e., size). Large-, mid-, small-, and micro-cap.
- Industry, sectors, and themes. Examples include technology, travel & leisure, education, e-commerce, etc.
- Growth vs. value. Growth, value, or blend.
I explore these subclasses in this article.
Summary
The number of investment products one can consider is growing, seemingly exponentially. While the investing world is vast, the main four types of asset classes are equities (i.e., stocks), fixed income (e.g., bonds), physical assets, and cash. These four types all play a role in a total financial portfolio.
Disclaimer: The contents of this website is an opinion and is for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice.