One of the core elements of asset management is diversification. This involves creating portfolios balanced across or within various asset classes. Before individuals start to invest their money, they should make an effort to understand the various asset classes, including the potential pros and cons associated with each.
Understanding this information makes it much easier to create a portfolio with the appropriate amount of risk and to have more realistic expectations about potential returns. The term “asset class” refers to a grouping of similar investment products.
Importantly, each of the major asset classes can be further broken down into sub-classes that look at differentiators like size, location, and industry. The basic asset classes are:
1. Commodities
These are physical assets and can include everything from natural gas to gold. Some soft agricultural commodities like wheat and rice are also traded.
2. Equities
This class includes stocks, which remain the primary thing individuals think about in terms of investing. A stock means that someone owns a piece of a company.
3. Cash
While most people do not think of cash as an investment, it does constitute an asset class. This class also includes cash equivalents, such as savings accounts, that may still accrue interest.
4. Fixed income
This asset class is all about debt. Individuals can lend money to a company or a government in return for interest payments. The most popular asset in this class is the bond.
5. Real estate
Many people make real estate a major part of their investment portfolios, whether that means residential rentals or larger retail spaces. Nowadays, individuals can invest in real estate through shares in a trust, which in turn invests in certain classes of property.
The Important Sub-classes of Equity Assets
While looking at equity assets, individuals may come across terms that they are not familiar with that can be used to further classify stocks. For example, equities may be classified as growth or value stocks.
A stock that is expensive relative to the income that it currently generates is a growth stock. Investors largely believe that the potential for future growth justifies the high price. Startups that actually have negative earnings by may grow fast in the coming years are often growth stocks.
Value stocks have a low price relative to the dividends they pay, although there will not likely be significant growth in the near future. Some stocks are a blend of both of these concepts.
The other concept to understand in relation to equities is market capitalization. This term simply refers to the size of the company. The market cap accounts for the total value of the company’s trading stock. A micro-cap company is very small, usually worth less than $300 million whereas a large-cap company is worth more than $5 billion.
Considering market capitalization is important since larger companies tend to be more stable than smaller ones, but they do not have the same potential for growth. Various funds or investors may focus primarily on companies of a certain size. However, individuals should recognize that micro-cap companies have a higher risk than those of other sizes.
Why Asset Classes Matter in Investment Management
Understanding the different asset classes is critically important. The first step in creating a portfolio often involves deciding on the ideal mix of these different classes. The mix depends on one’s risk tolerance.
One rule of thumb that some investors use is to subject one’s age from 110 and put that percentage of all invested money into stocks. This rule reflects the belief that individuals should tolerate less risk as they age. However, every situation is different, and people may want to invest more or less in stocks.
Investors who want to add physical assets like commodities or real estate may want to reduce the percentage they dedicate to stock. Many people will use the rest of investing money for bonds, which have a lower risk, but some individuals will also include cash. When it comes to cash, individuals should recognize that inflation will make cash worth less over time, so this asset class usually accounts for only a small part of the overall portfolio.
Asset classes also matter because individuals should diversify within those classes, especially when it comes to equities. As discussed above, individuals should have a range of different company sizes represented in their portfolios.
Most people will also diversify between growth and value stocks so that they maintain some potential for significant growth without accepting too much risk. Micro-cap companies have both high risk and high return, so they should have less of a role as people reduce their risk tolerance.
Also, it is important to think about some of the more liquid ways of investing in physical assets, such as choosing a real estate investment trust over a rental home. Such an investment walks the line between real estate and equity investment, but will behave differently on the market than stocks and thus provides diversification.