Asset Classes: What Are They and How to Use Them in Investing

An asset class is a grouping of investment types that have similar characteristics, including factors that influence their risk, return, and liquidity. Stocks, fixed income, cash and cash equivalents, and alternatives are the four main asset classes, with smaller classes within each category. For example stocks have large, small, and mid-cap varieties.

The allocation of asset classes in your investment portfolio is a key tool in diversifying it to balance risk and rewards. Investor.gov defines the process thusly: “Asset allocation involves dividing your investments among different assets, such as stocks, bonds, and cash. The asset allocation decision is a personal one. The allocation that works best for you changes at different times in your life, depending on how long you have to invest and your ability to tolerate risk.”

Types of asset classes

Investors can choose from a number of asset classes. The four main main ones are:

1. Stocks

Stocks represent equity ownership in the issuing company. You can invest directly in shares of individual stocks or through a mutual fund or an exchange-traded fund (ETF).

The main benefit of stocks is that they have the greatest potential to appreciate in price, generally outperforming other types of investments in aggregate over time. Some stocks also offer income from dividend payments.

Note that investing in stocks carries a good amount of risk. Though they can earn high returns in a rising stock market, you can lose money, sometimes quite a bit, when the market is down. Stock prices can also be affected by bad news involving the issuing company, such as reduced earnings or changed business prospects—or by such world events as political unrest and natural disasters.

2. Fixed income

Fixed-income securities are mostly bonds, which represent a loan to the issuer. They have a set maturity date and a specified interest rate. Purchasers receive interest payments, generally on a semi-annual basis, in exchange for the money spent buying the bonds. They can be issued by corporations, the U.S. Treasury, various other governmental agencies, states, and municipalities, among others.

The bond issuer has the use of the money raised from the sale of the bonds until they mature. In return the issuer pays interest to the bond holders. Upon maturity the face value of the bonds is returned to the purchaser.

Bonds can be purchased either directly through new offerings or on the secondary market, where their price can be higher or lower than their face value. Bond mutual funds and ETFs are another way to invest in bonds, but they carry an added level of risk, as they do not mature and thus can be subject to the direction of interest rates in terms of the fund’s value.

Another risk factor is the bond’s duration, which “measures the sensitivity of a bond’s price to changes in interest rates by calculating the weighted average time it takes to receive all the interest and principal payments.” Bonds with a longer duration will be more susceptible to a price decline than bonds with a lower duration.

The price of bonds generally moves inversely with the direction of interest rates. When rates rise, bond prices fall, and vice versa.

3. Cash and cash equivalents

Cash equivalent investments are generally safe investments that can easily be turned into cash when needed. They include various types of savings accounts, money market mutual funds, U.S. Treasury bills, and short-term certificates of deposit (CDs), among others.

Cash and cash equivalents comprise a low risk and highly liquid asset class. It’s generally the safest of the four main asset classes.

4. Alternatives

Alternatives are the least uniform of the four major asset classes. They encompass a wide range of of investments, including:

• Real estate.
• Gold and precious metals.
• Fine art and collectibles.
• Commodities.
• Lending.
• Cryptocurrencies.
• Crowdfunding.
• Private equity.

These and other alternative assets often have relatively low correlations to the other three, more traditional, asset classes. Investing in them generally entails a much less regulated investment environment.

Note that in many cases investors can invest in some types of alternative assets via a mutual fund or an ETF. This will lower the risk of direct investments in these alternatives, but it may also reduce return from them.

What is diversification?

Diversification in investing refers to owning a number of holdings across a range of asset classes. Which ones—and how much is allocated to each—will vary based on an investor’s risk tolerance, time horizon, and other factors particular to their situation.

The underlying principle is that different types of investments react differently to changes in the markets and the economy. It’s analogous to the old adage “Don’t put all your eggs in one basket. Diversification is the main driver of asset allocation.

How does diversification work?

If your only investment is a mutual fund that tracks the S&P 500 index, you are 100% exposed to the ups and downs of that index—and by default the U.S. stock market.

If you want to reduce your exposure to large-cap domestic stocks, you can add holdings from other asset classes that have a reduced correlation to them.. For example, bonds on the Bloomberg Aggregate Bond Index only have a 32% correlation with U.S. large-cap stocks. This means that 32% of the movement of the two asset classes is tied to the same market or economic factors, while 68% of the price movements is tied to different factors.

When building a diversified portfolio, it is important to include some asset classes that are not highly correlated with the other asset classes within the portfolio. This helps compensate for the effect of the inevitable down markets we see in stocks and bonds periodically.

Why is diversification important?

As noted above, diversification can help protect an investor during stock market downturns and other economic events that drive the financial markets lower. Investing only in a fund that tracks the S&P 500 is great when the market and that index are moving higher. Being in a fund also protects you against the varying share prices of individual stocks. However, when the markets head into an inevitable downturn, a portfolio invested solely in this type of fund will suffer the full brunt of the decline.

A well-diversified portfolio that holds a number of different investments across several asset classes that are not closely correlated to each other can provide a cushion during a market downturn. While you might not realize the full extent of the market highs, your portfolio will not suffer the full effect of the lows.

Diversification within asset classes

Beyond the main asset classes are a number of smaller ones. For example, stocks can be classified as:

• Large cap.
• Small cap.
• Mid-cap.
• Growth.
• Value.
• International.
• Blue chip.
• Income.

In addition, when it comes to mutual funds and ETFs, the share classes can get even more refined. For example, domestic stock funds can be built of value stocks, growth stocks, or a blend of both, all of which can contain large-cap, mid-cap, and small-cap stocks. A prime example of a large-cap blend fund is a mutual fund or ETF that tracks the S&P 500 index.

When looking to diversify your portfolio, it makes sense to look at a range of asset classes, but there is no need to overdo it. Just make sure that it’s done in line with your overall financial plan, which should include your investing time horizon, risk tolerance, and other related factors.

TIME Stamp: Investing in multiple asset classes is key to creating a healthy investment portfolio

Asset classes are groupings of like investments. The four main classes are stocks, fixed income, cash and cash equivalents, and alternatives. Investments in these broad categories have many similar characteristics in terms of risk and upside potential. Within them there are many smaller classes that vary in their characteristics.

Portfolio diversification involves investing across several asset classes. It helps investors build a portfolio that generates healthy growth while minimizing risk.

Frequently asked questions (FAQs)

What are the four main asset classes?

The four main asset classes are:

• Stocks (also known as “equities”).
• Fixed income (such as bonds).
• Cash and cash equivalents (such as CDs and Treasury bills).
• Alternatives (from precious metals to real estate to cryptocurrencies and more).

How do you explain asset classes?

Asset classes are broad categories of investment types that share similar characteristics. Within them are also smaller classes that allow for asset allocation at a more refined level. For example, small-cap value stocks are one specific category of smaller companies that are lower risk and often pay dividends.

What are the riskiest asset classes?

Stocks and alternatives are the riskiest, as their prices are so volatile. Stock prices rise and fall with the market, which can quickly reach both great highs and lows.

Alternatives encompass a broad range of investment types, including gold and precious metals, commodities, real estate, venture capital, and livestock—each with its own specific risks.

Fixed-income investments are far more predictable in what they will generate, while the greatest threat to cash and cash equivalents is the pernicious effect of inflation. Neither approaches the risks associated with stocks and alternatives.