An asset class is a group of securities that have similar financial characteristics, behave similarly in the marketplace, and are subject to the same laws and regulations. The three main asset classes are equities (stocks), fixed-income (bonds) and cash equivalents (money market instruments).
In addition to the three main asset classes, some investment professionals would add real estate and commodities, and possibly other types of investments, to the asset class mix. Whatever the asset class lineup, each one is expected to reflect different risk and return investment characteristics, and will perform differently in any given market environment.
Asset classes and asset class categories are often mixed together. In other words, describing large-cap stocks or short-term bonds asset classes is incorrect. These investment vehicles are asset class categories, and are used for diversification purposes.
Stocks - Also called equities
- Represent shares of ownership in publicly held companies
- Historically have outperformed other investments over long periods (keep in mind that past performance does not guarantee future results)
- Most volatile in the short term
- Returns and principal will fluctuate so that accumulations, when redeemed, may be worth more or less than original cost
Fixed income - Fixed income, or bond investments, generally pay a set rate of interest over a given period, then return the investor’s principal.
- Set rate of interest
- More stability than stocks
- Value fluctuates due to current interest and inflation rates
- Less volatile than stocks and bonds
- Lower potential for growth
- Short-term investment
Guaranteed - Guaranteed assets with a fixed rate and backed by the claims-paying ability of the issuing insurer.
- Preserves your principal
- Provides at least a specified minimum return
Real estate - Your home or investment property, plus shares of funds that invest in commercial real estate.
- Helps protect future purchasing power as property values and rental income run parallel to inflation
- Values tend to rise and fall more slowly than stock and bond prices. It is important to keep in mind that the real estate sector is subject to various risks, including fluctuation in underlying property values, expenses and income, and potential environmental liabilities.
Most financial experts agree that some of the most effective investment strategies involve diversifying investments across broad asset classes like stocks and bonds, rather than focusing on specific securities that may or may not turn out to be "winners." Diversification is a technique to help reduce risk. However, there is no guarantee that diversification will protect against a loss of income.
The goal of asset allocation is to create a balanced mix of assets that have the potential to improve returns, while meeting your:
- Tolerance for risk (market volatility)
- Goals and investment objectives
- Preferences for certain types of investments within asset classes
Being diversified across asset classes may help reduce volatility. If you include several asset classes in your long-term portfolio, the upswing of one asset class may help offset the downward movement of another as conditions change. But keep in mind that there are inherent risks associated with investing in securities, and diversification doesn’t protect against loss.