Asset Classes

investing
December 15, 2020

Diversifying your portfolio with multiple asset classes can help you manage risks when investing. An asset class is a collection of investments that have some similarities.

The four main assets classes are:

  • Equities
  • Bonds
  • Cash
  • real estate

The asset classes have different risk and return characteristics and play different roles in an investment portfolio. Combining different asset classes helps manage risks and create a balanced portfolio.

Equities (Stocks)

Equities are the same as stocks, which are ownership shares in companies.

With Equities there are two ways you can earn a return on investment. One way is when the company pays dividends, which are essentially a distribution of profits to shareholders. The other way you can make a profit with equities is through a capital gain when the share price of the stock increases.

Neither dividends nor capital gains are guaranteed. This means that investing in stocks involves some risk. A company can choose to reinvest profits instead of distributing dividends, and the share price could fall below the level at which you invested.

Bonds

Companies and governments issue bonds as a way of raising money. Bonds can be thought of as lending your money in exchange for regular interest payments and the return of your investment on a set date in the future. Bonds can also be sold before maturity at a price that depends on the interest rate environment at the time of sale. Bonds are rated by credit agencies based on the financial security of the issuing entity.

There are several risks to consider when investing in bonds:

  • Default Risk. Default is the worst risk. If the company, or government goes bankrupt, you could end up with a total loss of your investment, or get back only a portion of it.
  • Interest Rate Risk. The price of the bond falls when the interest rate rises. If you then sell the bond before maturity, you would fetch less money than your initial investment.
  • Inflation Risk. Bonds typically do not offer high returns. If inflation hits, the interest payments might not be sufficient to make up for the loss of value due to inflation. By the time the bond matures, you could have less money, in real terms, than you started with.
  • Downgrade Risk. If the financial situation of the bond issuer changes or the market environment changes, credit rating agencies could lower their rating of the bond. This will cause the price of a bond to fall. As with the inflation risk, if you then sell the bond before maturity, you would fetch less money than your initial investment.

Cash

Cash assets are either actual cash or other highly liquid assets. Some examples of cash assets are:

  • Checking Accounts
  • Savings Accounts
  • Certificates of Deposit
  • Money-market Instruments
  • Cash Funds (Funds that only invest in cash assets)

Cash assets typically offer lower yields than stocks, bonds, and real estate. However, cash assets can still play a role in your portfolio as they can help maintain safety and liquidity. They can also be used as a temporary home for your money in between longer-term investment opportunities.

Real Estate

A real estate is land and any permanent improvement attached to the land, including buildings and homes. There are different ways to invest in real estate. Two common approaches are:

  • Purchasing properties directly
  • Buying shares in a Real Estate Investment Trusts (REITs)

REITs are companies that deals in real estate properties and pay a large part of their income as dividends to shareholders. Just like stocks, shares in REITs can be bought and sold throughout the trading session. This makes investtments in REITs very liquid and much simpler than buying properties directly.

When buying properties directly, there is a much larger effort needed to go through the process of finding good opportunities, arranging financing, signing contracts, and potentially doing some fixes and renovations to the property. With the direct purchase approach, your investment is not liquid as the selling process can be quite long, unlike selling shares in a REIT. Nonetheless, a good real estate investor can achieve better returns buying properties directly. This is simply because the investor can sometimes find good bargain opportunities and also use debt as leverage.

There are two ways to earn a return with the direct buying approach: either by a rental income, or by selling at a higher price.

When investing in real estate, there are various risks, including fluctuation in underlying property values, delays in finding tenants or buyers, and potential environmental liabilities.

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