An asset class is basically a group of similar types of investments. These investments can be broken down into sub-classes which is primarily driven by the risk and return potential. Each asset class reflects different risk and returns characteristics, and performs differently in a particular market. Broadly they are classified into:
· Equities or stocks
· Fixed income or bonds
· Cash and cash equivalents
· Alternative investments
Equities or stocks
Equity basically means owning a piece of a company. When you invest in a publicly traded company, you get a stock certificate that indicates how many shares of the company you own, and serves as your proof of ownership. Apart from identifying and investing in the companies you wish to, you need to consider other factors like the purpose you want the returns to serve, or what kind of stock ownership benefits you. In the long-term, stocks are known to earn higher and more consistent positive returns than any other financial investment.
Fixed income or bonds
A bond is a formal contract to repay borrowed money with interest at fixed intervals. Bonds provide the borrower with external funds to finance long-term investments. Bondholders have a creditor stake in the company, which makes them lenders. Typically, people like to invest in bonds because they pay interest semi-annually, providing a predictable stream of income. Invest in bonds if you are looking for the interest income and want to preserve your capital investment.
Cash and cash equivalents
A cash investment is a short-term obligation that provides returns in the form of interest payments. It consists of negotiable instruments such as treasury bills, commercial papers and certificates of deposit, and is used by many participants, including companies, to raise funds by selling commercial papers in the market. Investors, who opt for this kind of investment, benefit from its low-risk yield and high liquidity.
Alternative asset classes
There are many more alternative asset classes. These include assets like commodities, real estate, precious metals, agricultural land, machinery and oil, international investments, hedge funds, bitcoin etc. People prefer to invest in alternate asset classes for times when the more popular asset classes fail to perform. The flip side to this is that generally, more unconventional the investment, lower the liquidity. This means although the returns on these assets can be liquidated, it might take more time to find a buyer to liquidate them.
The bottom line
Asset classes play a vital role in the overall portfolio performance. It is said that around 80% of the overall portfolio performance is the result of selection of the asset classes and only 20% is reflective of individual assets within each class. As each of the asset classes vary in terms of their risk and return characteristics, they play an important role for the overall portfolio diversification.