||This article should be divided into sections by topic, to make it more accessible. (November 2016)|
An asset class is a group of instruments which have similar financial characteristics and behave similarly in the marketplace. We can often break these instruments into those having to do with real assets and those having to do with financial assets. Often, assets within the same asset class are subject to the same laws and regulations; however, this is not always true. For instance, futures on an asset are often considered part of the same asset class as the underlying instrument but are subject to different regulations than the underlying instrument.
Many investment funds are composed of the two main asset classes which are securities: equities (stocks) and fixed-income (bonds). However, some also hold cash and foreign currencies. Funds may also hold money market instruments and they may even refer to these as cash equivalents; however, that ignores the possibility of default. Money market instruments, being short-term fixed income investments, should therefore be grouped with fixed income.
In addition to stocks and bonds, we can add cash, foreign currencies, real estate, and commodities to the list of commonly held asset classes. In general, an asset class is expected to exhibit different risk and return investment characteristics, and to perform differently in certain market environments.
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
- includes "guaranteed" or "risk-free" assets
- Also includes money market instruments (short-term fixed income investments)
Foreign Currencies - Also called FX, or foreign exchange
- No bearish periods, as when one currency's value falls, others' will in turn rise
- The only truly 24-hour tradeable asset class
- Highly speculative (97%) market
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.
Commodities - Physical goods such as gold, copper, crude oil, natural gas, wheat, corn, and even electricity.
- Helps protect future purchasing power as values have fixed utility and thus run parallel to inflation
- Values tend to exhibit low correlations with stock and bond prices.
- Price dynamics are also unique: commodities become more volatile as prices rise. Thus a commodity with a 20% volatility might have a 50% volatility if prices doubled.
Most financial experts[who?] 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.