Asset Classes 101: What Are They and How Do They Work?

The financial markets have evolved quite rapidly in the past few decades as a result of the introduction of technology to enhance many of its processes. Moreover, financial engineering has also made quantum leaps by securitizing different kinds of assets into vehicles that investors can buy to further diversify their portfolios.

Considering the complexity of today’s markets, beginner investors should start their journey by understanding the many asset classes that they can invest in so they can make more informed decisions on what to include in their portfolios.

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What Is an Asset Class?

An asset class is a category that groups certain investable tangible and intangible instruments that share similar characteristics. Asset classes are divided, among other reasons, to facilitate the process of tracking their performance over time and assessing their risk and earnings-generation capacity.

Moreover, portfolio allocation decisions are also facilitated by grouping assets into homogeneous categories as this contributes to reaching appropriate levels of diversification.

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Types of Asset Class

The rapid evolution of financial markets lately has also expanded the number of asset classes that can currently be incorporated into a portfolio. In this section, we discuss both traditional and exotic asset classes, what they are, and which instruments are categorized as such.

Cash & Cash Equivalents 

Cash is the oldest and perhaps more traditional asset class. This asset class is the most liquid of all and it includes all instruments that can be converted into cash instantly along with bank deposits and physical banknotes. In most cases, the maximum maturity of the instruments that are considered cash equivalents is three months.

Cash is considered risk-free because of the variability of its returns. However, inflation and devaluation are two important risks that can erode the purchasing power of cash holdings. Meanwhile, the returns typically earned from holding cash equivalents are low due to the low risk of these instruments.

These instruments are considered cash and cash equivalents:

• Physical banknotes
• Bank deposits
• Certificates of Deposit (CDs)
• Marketable securities (short-term commercial papers and US government bonds)
• Money-market funds

Equities 

Equities represent the interest of an investor in a given business venture. The most common form of equity is stocks but these instruments can also be divided into multiple categories depending on the location of the business that issues them, the sector in which the company participates, and its size.

Equities are typically divided into two groups: common and preferred stocks. Common stocks give the holder a percentage of ownership over the business and common stockholders are entitled to receive any dividends approved by the Board of Directors along with capital gains.

Common stocks also give the owner the right to vote on crucial company matters during the general assembly — also known as the shareholders’ meeting. Meanwhile, preferred stocks entitle the holder to receive a fixed dividend periodically. 

Equities are typically considered riskier than cash and fixed-income securities as gains vary depending on multiple factors. This additional risk is compensated by higher expected returns, primarily from the potential appreciation in the value of the asset. 

Here is a breakdown of how equities are typically classified:

• By type: Common or preferred
• By size of the issue: Small-cap, mid-cap, large-cap, mega-cap 
• By geographical location of the issuer: US-listed stocks, foreign 
• By class: Class A, Class B, Class C, etc.

Fixed-Income

Fixed-income securities are instruments that entitle the holder to receive periodic payments whether those are dividends, interest payments, or profit-sharing arrangements.

There are multiple types of fixed-income securities going from mid-term to long-term government-issued bonds to corporate bonds.

These securities are typically granted a credit rating from agencies like S&P Global Ratings or Fitch Ratings. The rating reflects the creditworthiness of the issuer and the likelihood that a default can occur. Insolvency risk is the most important to appraise when investing in fixed-income securities.

On average, the gains produced by fixed-income instruments tend to be lower than those generated by equities and alternative investments due to their lower appraised risk.

Fixed-income securities can be classified as follows:

• By issuer: Government, corporate, municipal, agency bonds, etc.
• By maturity: Short-term, mid-term, and long-term bonds
• By rating: Investment-grade or junk bonds
• By type: Asset-backed, first-lien, convertible, unsecured notes, etc.

Alternative Investments

Alternative investments are perhaps the largest category of all considering the ample number of assets that are included in this group. 

This asset class has been gaining popularity recently as investors have sought new potential ways to diversify their portfolios and increase their returns without taking too much extra risk.

The risk carried by alternative investments varies from one asset to the other. For example, the risk of investing in real estate is markedly different from that of cryptocurrencies. Meanwhile, gains can be produced via periodic dividends or interest payments and in the form of capital gains.

Here’s a list of the most common alternative investments:

• Real estate
• Cryptocurrencies
• Commodities
• Derivatives (options, futures, etc)
• Precious metals (gold, silver, etc.)
• Private equity
• Hedge funds 
• Venture capital
• Peer to Peer Lending
• Collectibles
• Fine wine
• Fine art

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Understanding Asset Classes

By understanding the different characteristics of all existing asset classes, an investor can have an ample range of choices to build a diversified portfolio. One common portfolio design is the 60/40 allocation, which puts 60% of the capital into equities and the remaining 40% into fixed-income securities.

However, with the rise of alternative investments, investors now have many more choices when building their portfolio and they can determine both broad and segmented allocations per asset class as needed.

That said, learning about asset classes is only the first step as it is also important to be familiarized with both the historical performance and risks that each class carries. This helps the investor in determining the percentage that should be allocated to each asset class to maximize returns.

Most financial planners and other professionals within the industry use complex mathematical models that run multiple iterations using the historical performance and risk — typically expressed as the standard deviation of results during long periods — to estimate the optimal portfolio composition that maximizes returns for a given level of risk.

An investor’s risk tolerance and financial goals are typically the most important variables that should be considered when determining the right portfolio composition as not all investors are created equal.

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Asset Allocation & Strategies

As discussed previously, asset allocation depends more on the risk tolerance of the investor than on the performance of the asset classes that will be included. For example, some investors may not tolerate a 10% decline in the value of their portfolio while others might not be emotionally affected by a 30% short-term decline.

With this in mind, there are five typical portfolio allocation models that investors can follow based on their risk tolerance:

• Conservative: Primarily focused on income generation with little to no fluctuation in principal value
• Mildly Conservative: Mostly focused on income generation with mild exposure to high-quality, variable-income securities
• Balanced: tThe same weight is assigned to every asset class.
• Mildly aggressive: More weight is assigned to high-risk/high-reward asset classes.
• Aggressive: Almost the entire portfolio is allocated to high-risk/high-reward asset classes. The goal is to produce capital gains, not income.

Other strategies used to build portfolios focus on the investor’s financial goals including the following:

• Growth
• Value
• Dividend
• Tactical asset allocation
• Hedged
• Cyclical

The following is a sample breakdown of a risk-taker’s portfolio:

• Equities – 50%
  • 25% US mega-cap stocks
  • 30% US large-cap stocks
  • 15% US mid-cap stocks
  • 20% US small-cap stocks
  • 10% foreign stocks
• Fixed-income securities – 20%
  • 50% investment-grade bonds
  • 25% convertible notes
  • 25% junk bonds
• Alternative investments – 25%
  • 30% cryptocurrencies
  • 30% REITs
  • 20% fine wine
  • 20% fine art
• Cash and Equivalents – 5%
  • 50% money-market funds
  • 50% bank deposit

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Final Thoughts

Now that you know more about asset classes, you should be able to differentiate between the different types of portfolios available to you and pick the one that suits your financial goals and risk tolerance the best. Make sure you check out our appreciating assets guide to learn more.