What is the Relationship Between Different Asset Classes?

What is the Relationship Between Different Asset Classes?

In the investment world, individual investments are categorized together into broad classes of similar assets. Some examples of these asset classes include familiar categories like stocks, bonds, and real estate. While all investments respond to overall market conditions, they also have interdependent relationships with each other. Here’s what you need to know about the relationships between common asset classes.

The Four Key Markets

In investing, there are four key markets that are the most important. These markets are grouped into pairs that have a push-pull relationship with each other. The balance of these markets changes in response to various economic factors, such as inflation and interest rates. Below, you’ll find descriptions of these pair relationships and how they are affected by general economic conditions.

Stocks and Bonds

The first relationship among asset classes you should understand is the one between stocks and bonds. These are the two main asset classes that compete for investors’ capital, meaning that there is a fairly strong inverse relationship between them. Bonds tend to retreat as stocks rise due to the fact that they offer much lower rates of return.

The balance between these asset classes typically shifts toward stocks during periods of economic growth. When stocks fall, bonds tend to rise as investors seek safer havens for their money. Inflation also tends to work against bonds since a drop in purchasing power can quickly erode their fixed yield rates.

There is, however, some nuance to how this relationship works. Safe dividend stocks, for example, are more likely to move with bonds than against them. This is because their predictable yields make them more like bonds than growth stocks. Falling bond yields can also drive the prices of older bonds that still pay higher rates up, creating a separate, internal push-pull relationship within the asset class. Bond prices falling due to increases in interest rates can also signal a stock retreat as higher interest rates raise the cost to companies of borrowing money for capital investment.

Commodities and Currency

Like stocks and bonds, there is a generally inverse relationship between commodity prices and the strength of the dollar. When the dollar strengthens, its purchasing power rises, and commodities can be purchased for fewer dollars. Likewise, a weak dollar tends to indicate higher commodity prices. High inflation can have a profound impact on this relationship, since it rapidly erodes the value of currency. During inflation spikes, commodity prices can rise significantly. 

While all currencies have some relationship to commodity prices, the dollar is the most important for investors to understand. This is because the dollar’s stability makes it the default reserve currency of the global economy. As a result, many commodities are purchased using US dollars.

Other Asset Classes

In addition to the four primary markets, there are many other classes of assets that respond to changes in the overall economy. Two of the most important of these classes are real estate and precious metals.

Real Estate

Real estate prices are inversely related to interest rates and tend to be correlated to inflation. When interest rates are low, more buyers are likely to originate new mortgages. Assuming the housing supply doesn’t rise at the same speed as new demand, the price of real estate will rise. This increase in housing costs can contribute to inflation throughout the economy.

The value of real estate for an investor is the fact that it is a generally safe investment. While values may go down temporarily, the limited supply of land tends to support stable real estate prices. Unlike a publicly traded company or bond-issuing entity, a piece of real estate can’t vanish in default during times of economic turmoil.

Precious Metals

Like real estate, precious metals are physical stores of value that investors can rely on in difficult times. Precious metals are largely unaffected by inflation, making them a preferred investment during periods when inflation is running high. Unfortunately, precious metals offer little in terms of returns. As a result, most investors view these metals more as a hedge than as a growth investment.

How to Capitalize on These Relationships

While all investors should have a grasp of these basic principles, the overwhelming majority will be better off pursuing a passive, diversified investing strategy that doesn’t actively change in response to market conditions.

Overall, the inverse relationship between many of these asset classes means that when certain ones go down, the others could go up under specific conditions. A properly diversified portfolio that contains a mix of asset classes can help you leverage this relationship. Basically, it allows you to minimize the risk of being impacted if any one asset class drops in performance, as you are also invested in other asset classes that can perform in the opposite direction.

Only highly skilled experts should make active investing their primary strategy, since passive, diversified strategies (such as the balanced plan mentioned above) tend to perform better for the ordinary investor over time. It also helps minimize investment stress and emotional reactions to market fluctuations, as you remain invested across different asset classes without worrying about buying and selling as you go. Sign up with SmartWealth for a diversified, global, passive investing plan that will help your money work for you in all types of market conditions, while balancing your investment risk and peace of mind.

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