When dealing with investments, it's essential to understand the different asset classes and which investments fall into each. An asset class is a collection of investments that share similarities—including how they behave in the marketplace, the purchasing process, and how the government regulates them. Historically, there have been three primary asset classes, but today financial professionals generally agree that there are four broad classes of assets:
- Equities (stocks)
- Fixed-income and debt (bonds)
- Money market and cash equivalents
- Real estate and tangible assets
If your portfolio includes investments spread across the four asset classes, it's considered balanced—which is ideal because it helps to reduce risk while maximizing return. If your portfolio is particularly heavy in one sector and that sector underperforms for some reason, you could be in trouble. If your portfolio is spread out relatively evenly and just one asset class experiences difficulties, you should still have the others performing adequately enough to pull you through the crisis.
Equity represents ownership. When you purchase shares in a company, you're purchasing ownership in that company. For example, if Company ABC has 100,000 shares and you buy 1,000, you will own 1% of Company ABC. As part-owner, you have rights to a portion of a company's profits, and these are usually paid out to investors in the form of a dividend. The dividend amount varies by company, and some companies may choose to use the dividends to reinvest back into the company for growth.
Although stocks are lumped together, the same investing principles should not apply to them as a whole. For example, investing in a hyper-growth startup is very different from investing in a blue-chip stock that's been around for decades.
Fixed-Income and Debt
Whenever you purchase an institution's bonds, you're essentially lending them money—which is why they represent debt. In return for this loan, the institution promises to pay interest on the loan in the form of periodic payments. These interest payments are paid to bondholders throughout the life of the bond, and the principal is returned at the end of the term (referred to as the maturity date). For example, if you buy a $1,000 5-year bond with an annual interest rate of 2%, you'll receive biannual payments of $10.
Money Market and Cash
Cash is any money in the form of currency, both local and foreign. This can include physical bills and coins and the cash you have in your bank accounts. Cash equivalents, like money market holdings, are highly liquid investments that can readily be converted into cash—usually within 90 days or less. Unlike stocks and other assets, cash equivalents must have a determined market price that doesn't fluctuate.
Real Estate and Tangible Assets
Tangible assets—ones you can physically see and touch—are grouped into their own asset class. Real estate is the most common type of tangible assets that people own, but commodities, like gold and livestock, also fall into this category. Generally, these types of assets can withstand periods of inflation.
Use All Four Classes
The purpose of having all four asset classes represented in your portfolio is not only to prevent investment downfalls but also to take advantage of the different strengths of each class. The whole theory of asset allocation is based on diversifying your portfolio by asset class; you never want to find yourself in a situation where your portfolio is reliant on one asset class to carry the weight. Stocks give you a chance for higher returns, but they also come with more risk; bonds don't offer substantial gains, but they're one of the safer investment options. It's on you to find out which combination of assets makes the most sense for you.
The younger you are, the more aggressive your portfolio should be. As you get closer to retirement, your portfolio should get more conservative because you don't have as much time to rebound in the event of a market downfall.
The Bottom Line
A portfolio that contains only one or two asset classes is not diversified and may not be prepared to take advantage of all the swings the market can throw at you. But diversification—or at least the degree to which you diversify—is also an individual decision that depends to some extent on your goals and risk tolerance.
If you're particularly risk-averse, you might want to diversify even more or make sure you're further diversified within each class, allowing for minor differences within that class. If you have nerves of steel and you're lucky enough to have money to burn, you might not want to rely on diversification quite as much but ride the trends of the market instead.