Asset Classes Explained
If you read the financial press or any money or investing related websites, including Money Mentor, you will often hear the phrase Asset Class or Asset Classes banded around. As these are key elements of an investors plan, we will explain what asset classes are in an easily understandable format below.
An asset class can be thought of as a broad group of investments that have very similar financial characteristics and behave in a certain and similar way.
Some commentators suggest there are four main asset classes, but we will expand that theory to five as shown below:
Stocks & Shares (sometimes called equites)
Bonds (sometimes called fixed interest)
The different asset classes have different levels of risk, ranging from low-risk assets such as cash to high-risk assets such as stocks and shares and commodities. This mixing of different asset classes together in different proportions is known as asset diversification and is another key area to fully understand on your way to becoming a more experienced investor yourself.
Cash as an Asset Class
Cash is by far the easiest asset for most people to understand as it forms a part of everybody’s day to day life, whether we like it to or not. Cash is the lowest risk asset class in the group, as cash in a bank account or in a jam jar or under the mattress can’t actually lose any capital value, so it is classed as very low risk. That said, there is a risk of holding cash if you are not earning enough interest to beat inflation, as the spending power of your cash will reduce over time, as inflation erodes its value, so please don’t think of holding cash for long periods of time as completely risk free.
Stocks & Shares as an Asset Class
Stocks and shares or equities are probably the second most well-known asset class behind cash, however, they are far from similar in how they behave from an investors point of view. Stocks and shares are simply very small ownership rights of publicly listed companies or businesses from anywhere around the world. You could own a stock in Amazon from the USA or Shell from the UK, or quite literally any other country in the world who trade shares. The key thing to know about stocks and shares ownership is that the value of your shares or holdings can go up or down dramatically, and you could even lose it all if the company you have invested in collapses. This is why stocks and shares are considered a high risk asset class.
Bonds as an Asset Class
Bonds, frequently termed fixed interest assets, can be issued by companies or businesses or even Governments. A bond is simply an IOU that says that the bond issuer will pay the bondholder a certain fixed interest over a certain period of time, for example 5% per year for five years, this is known as the bonds coupon or interest rate. Bonds can be classed as both medium risk and high risk assets as there are many different types and classes of bond available. Government bonds would be classed as lower risk, whereas developing market or high yield bonds, otherwise known as junk bonds would be classed as high risk or very high risk depending on which ones you bought. Like shares, the value of your bonds can go up and down, and you may lose all your money if a bond issuer company fails. That said, bonds are usually considered less risky than shares.
Property as an Asset Class
Property has become quite popular in recent decades as many people see property as a sort of retirement planning investment for the long term. You don't have to purchase your own home to invest in property as there are many property type funds available to invest in for those with less capital to invest with. As everybody will be well aware of by now, property prices can both go upwards and downwards and on occasions move very quickly. The other main drawback with property investing is that it takes some time to sell a property investment by which time you may have incurred significant losses already. Therefore property investing is considered a high risk asset class.
Commodities as an Asset Class
Commodities can be described as things that are bought and sold in various markets and places around the world, for example gold, silver, copper, iron, coffee, oil, lean hog and beans are all different types of commodities that can be bought and sold and traded on Commodity Exchanges. Many peoples portfolios will contain some commodities such as gold or silver or platinum in order to get a broad diversification of assets. However commodity investing is also classed as a high risk asset, and should only form a small part of your portfolio.
A well diversified portfolio will contain a mix of most asset classes but with some asset classes containing more allocations than others depending on your own risk appetite.