New investors are often inundated with information about different classes of assets. If you’re just getting into the finance world for the first time, asset classes and their uses may seem daunting. Here’s what you need to know about asset classes, their individual characteristics, and how they fit into a diversified portfolio of investments.
An asset class is a group of investment instruments that function similarly in the market and share basic characteristics. Asset classes also have a legal component, as investments grouped together into an asset class are subject to similar regulations. Different asset classes are frequently mixed together to and mitigate market risk.
Equities are a class of assets composed of units of ownership in business entities. The most common form of equity is a stock, which is a unit of ownership in a publicly traded company. These assets appreciate or depreciate as the company grows or shrinks. Some stocks also offer cash flow in the form of monthly, quarterly, or annual dividend payments.
Fixed-income securities are debt instruments that entitle the holder to regular interest payments, along with the repayment of the debt’s principal at an agreed-upon date. Bonds are the most common type of fixed-income instrument. These instruments can be issued by either public or private entities, and the rate of interest varies according to the credit rating of the issuer and the risk of default.
Cash is perhaps the most basic asset class and acts as the conversion medium for all other classes of assets. Cash equivalents are instruments that are readily convertible into cash and therefore act similarly to it. Money market funds and short-term government bonds are examples of cash equivalents that you might include in your portfolio as a retail investor.
Real estate is a very broad asset class describing property held for investment purposes. This asset class can be subdivided into smaller sub-classes, including office space, single-family homes, multi-family properties, farmland, and industrial space. Real estate investors realize returns on their investments from both property appreciation and rents paid by tenants.
Commodities are physical goods and natural resources that have value in the investment market. Agricultural products, gold, oil, lumber, industrial metals, and a host of other raw materials fall into this category. Commodities traders profit from volatility in the prices of these materials by buying and selling futures contracts.
Each asset class has its own level of risk and return that you should consider when allocating assets in your portfolio. Stocks and equities, being , are best for more risk-tolerant investors who are planning to build wealth over long periods. Cash and cash equivalents are very conservative and are most useful for short-term saving. Bonds offer a middle ground, with less risk than securities but more reward than cash. Real estate risk is variable, depending on the type of property you purchase and the amount of debt you take on to finance it. Because of the highly leveraged nature of futures contracts, commodities trading is a high-risk venture.
The right blend of assets for your portfolio will depend on your appetite for risk, age, income, and financial goals, among other factors. The best investment strategy, however, has historically been to to limit dependence on any single asset class.