Making the foray into the world of investments is a necessary journey, however daunting it may seem. While it is always imperative to seek the guidance of a professional, it is pertinent to equip oneself with some basic knowledge before beginning your inquest.
Here, we take a look at the different types of investments (asset classes) you can make and how they relate to each other.
What are Asset Classes?
An asset class is simply a grouping of similar types of investments. For example, if you invest only in these types of produce – apples, bananas, pears, and watermelons – your general asset class would be “fruits”.
The big general asset classes are as follows, and each of these can be broken down into sub-classes by size, industry, location, etc.
- Equities (stocks): They are shares of ownership issued by companies. Buying shares of companies listed on the Stock Exchange gives you percentage ownership of such companies for the period you hold those shares.
- Fixed Income (debt): Unlike equity investing, fixed income investment entails an investor lending his funds to a borrower (company, government, etc.) with the view of earning a fixed interest return over the life of the fixed income instrument. Various fixed income instruments include government bonds, commercial papers, treasury bills, etc.
- Cash and cash equivalents: Cash and cash equivalents are suited for short-term investing. The primary advantage of such investments is their liquidity. Cash equivalents, such as money market instruments, commercial papers, treasury bills, etc., are highly liquid instruments with maturity up to 1 year. Thus, money invested in cash and cash equivalents is easily accessible.
- Real Estate and Commodities: Owning something physical like property, natural resource commodities, and precious metals like gold. The tangibility of real estate investments is a crucial characteristic and makes it different from securities that exist only in virtual or dematerialized forms.
Choosing an Asset Class and Portfolio Mix
Generally you should take less risk as you age because you have less time to recover from a severe loss. A great rule of thumb is to subtract your age from 110 and put that percentage in stocks and the rest in bonds. So if you are 40, put 70% in stocks (110 minus 40) and the rest in bonds (30%). If you would like to add physical assets and a little cash to the mix, maybe reduce your stock allocation to 60% and your bond allocation to 25% and add in 10% real estate and 5% cash. Be careful not to keep too much of your investment portfolio in cash since inflation will make cash worth less overtime.
An individual can pick a precise asset allocation strategy or a combination of different strategies thereon based on their needs. However, be mindful that asset allocation strategies involve reacting to market movements and call for research as well as expertise in using specific tools to gauge the market.
A basic understanding of these various types of asset classes and investment strategies helps build a balanced portfolio. A diversified portfolio comprising of different types of asset classes helps reduce the overall risk to the portfolio as its overall performance is not affected due to a lag in any single asset class. This is because, usually, no two markets perform the same simultaneously.
The primary idea behind diversification is to match portfolio returns with your expectations and minimise overall risk and losses. While diversifying your portfolio, you should allocate the percentage of funds after primarily considering your financial goals, risk appetite, and investment horizon.
If you’re risk-averse, you might consider investing in relatively safer investment securities. On the other hand, if you have a high-risk tolerance, you might consider investing in funds that have equity as their principal component.
Mutual funds offer you the benefit of investing in various asset classes via diversification to reduce the overall risk on your investment.
