If you’re a beginning investor, you have likely been asked to consider what asset classes you’re interested in putting your money in, and are probably wondering what they are—and what difference it makes. Well, have a seat, because asset class is now in session.
What is an asset class?
A “class” refers to a set of items that have characteristics in common—think of a class of third graders or a certain class of car. Therefore an asset class is a way to categorize different types of investments with similarities: Each item in a given asset class is going to react in a similar way to financial fluctuations, but differently from the other asset classes. For example, as a large generalization, in a hot economy, most stocks go up, but bond prices go down. That’s because different asset classes react to market conditions differently, as we will explore.
When you invest in a certain asset class, you are putting your money into that type of investment, each of which has pros and cons depending on your investment strategy.
What types of asset classes can I consider?
Historically there have been three main types of asset classes:
Also known as equities, buying a stock means that you are buying a share of that company. In other words, when you buy a stock you own a piece of a specific company, which means that its value will rise or fall based on that company’s performance—or more accurately, investors’ perception of that company, which is really what drives a stock to go up or down. As an asset class, stocks are considered to offer greater risk than xsome other ones, like bonds, but also have the potential to offer a higher return. Stocks typically are classified as “large cap” (those with market capitalizations above $10 billion) or “small cap,” with large cap considered the more stable.
Also called fixed income products, bonds are a loan you offer an issuer, basically an IOU. While most people think of government bonds, such as treasuries issued by the U.S. government, or municipal bonds from states and cities, companies also issue their own corporate bonds. Though bonds are typically considered a safer investment, this asset class has variables as well, from the lower risk U.S. bonds to corporate bonds which offer greater risk (and thus, again, greater potential reward). Remember, of course, that no investment is “safe,” per se—there is always a level of risk.
Cash equivalents or money market vehicles
This isn’t just the cash you yourself have on hand. It refers to short-term loans, typically less than a year, which pay regular interest. This asset class usually takes the form of money market instruments like certificates of deposit (CDs) or promissory notes. These represent the lowest-risk (and lowest-return) investment of any, other than actual cash, and are liquid, meaning which you can tap their value as needed. Their benefit as an asset class is that they provide safety, such as for a very short-term need like an emergency fund, while still offering a better return than you’d get with your money sitting in your bank account.
While those are the “big three” asset classes, as investing has grown more complex, newer types of investments have emerged that are now also considered discrete asset classes, such as:
The most common types of real estate are residential, commercial, retail and industrial, all of which can be their own investment vehicles, but are all considered part of the same asset class. If you don’t want to (or can’t afford to) own an entire office building or apartment complex, you can invest in real-estate investment trusts (REITs), which means you are buying shares of a corporation that owns these properties.
This asset class refers to raw materials that create other products. Common commodity investments include metals, like gold and silver; agricultural products, like grain or cattle; and energy, like natural gas and oil.
One of the newest and thus “emerging” asset classes, cryptocurrency is still a bit of an unknown in the investing world. While most people think specifically of “Bitcoin,” there are thousands of other cryptocurrencies, both large and small. For example, you may have heard of Ethereum or Litecoin, and even Facebook has made an attempt to launch its own product. Cryptocurrency is essentially a digital token, esteemed because it is free of government regulation. When ranking asset classes, this likely would be one of the riskier ones, since so little is yet known about how cryptocurrency might react in a crisis.
Why are there so many asset classes?
Options are great for everything, and certainly for investment portfolios. That’s because investors require a diverse range of investment vehicles that allow them to reach their goals. Asset classes each accomplish different goals that can align with the goal of your portfolio.
For example, one factor investors should consider is their risk tolerance, which means whether they are equipped to endure the ups and downs of the stock market, either financially or emotionally.
Another is their time horizon, which refers to how long investors have until they need the money. For example, a 20-something who is just starting to save for their future retirement has a long time horizon, while someone who is nearing retirement has one that is short.
Your risk tolerance and time horizon combine to give you insight into whether you should create an aggressive or conservative portfolio, and that will help dictate which asset classes should be included. While many asset classes offer a variety of options that could suit an investor on either end of the spectrum (for example, blue-chip stocks can be more stable and thus conservative, compared with the more aggressive nature of emerging tech company stocks), there are other asset classes, such as bonds, that tend to lean toward a specific propensity, in this case, a more conservative asset class.
Which asset classes are the best investment?
The best investment products are the ones that suit an investor’s individual goals and take into account their risk tolerance and time horizon. But the important thing to remember is to ensure that your portfolio is diversified—in other words, it contains a broad range of asset classes. That provides a measure of safety in different market conditions, as each asset class will respond to the variables differently. In addition, diversity allows you to benefit from the various advantages of each type of asset class.
While you can choose to purchase individual stocks or bonds as a way to diversify your portfolio, you also can simplify your strategy by investing in funds, which by their nature already include an element of diversification. That’s because a fund is essentially a variety of securities. Mutual funds are actively managed by an investment professional who aims to beat the market by buying and selling at just the right time, while index funds are designed to mirror the market, generating earnings that equal the returns of a stock market index, such as the Dow or the S&P 500. Another type of fund to consider is an exchange-traded fund, or ETF, which is a “basket” of investments that trades on the stock market just like a stock.
In fact, ETFs are our favored investment vehicle at Acorns that we use to build our portfolios. We make sure to include a range of asset classes, grouped according to your needs—from conservative to aggressive. Acorns investment portfolios provide exposure to a diverse array of asset classes, which might include:
Large company stocks
Small company stocks
Given the mix of the ETFs that Acorns includes in its portfolios, investors have exposure to thousands of stocks and bonds, thus checking every box in the diversification category, while still allowing investors to choose the investment strategy that’s right for them.
And when it comes right down to it, that’s the secret sauce of asset classes. Each investor should choose a combination that reflects their needs at any given time, taking care to prioritize diversification in order to achieve the best possible financial outcome.
Investing involves risk including loss of principal. This article contains the current opinions of the author, but not necessarily those of Acorns. Such opinions are subject to change without notice. This article has been distributed for educational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.