“Know what you own, and know why you own it.”
— Peter Lynch
Your investments are a part of what you own, so you should invest wisely. A carefully devised investment portfolio is key to long term gains, and minimal risks. There is no way you can avoid risk altogether when you start investing, so the ideal situation is to reduce the likelihood of financial loss on your investments by as much as you can while maximizing the profits you make out of each investment. How can one go about doing that? It’s by diversifying your risk.
What is the best way to diversify your risk in your investment?
The answer is simple – by investing in different asset classes.
In the words of Michael LeBoeuf,
“An asset allocation plan is based on your personal circumstances, goals, time-horizon, and need and willingness to take risk.”
This article explains what asset classes are, their different types, and what investing in each asset class can bring to your table.
There are a multitude of investment options available in the market today. To make it easier for a layman to understand what type of investment there are, what risks they come with, what the gratuity period of each one is and how stable or liquid these are, they are divided into broad categories known as asset classes.
An asset class, in its essence, can be defined as a group of similar investment vehicles or opportunities. These assets have been grouped together because they have a similar financial structure. The similarities include:
The investment categories that have similar features based on the ones mentioned above are grouped together in one asset class.
Now that we understand the meaning of an asset class and what components are involved in making an investment a part of an asset class, let’s look into getting a better idea of what the popular types of asset classes are.
“The most important thing you can have is a good strategic asset allocation mix. So, what the investor needs to do is have a balanced, structured portfolio – portfolio that does well in different environments… We don’t know that we are going to win. We have to have diversified bets.”
— Ray Dalio
Understanding the different types of asset classes will help you make sound, diversified investments that will safeguard your finances, minimize your risk, and increase the probability of high returns. To gain a better understanding of which investments are right for you, you need to understand the asset classes they belong to first. The most widely recognized asset classes are mentioned below.
These are the liquid assets you hold. By liquid assets, we mean the assets that can be encashed easily and in a short period of time. These include savings accounts in your bank, or actual cash you have. These accounts are usually used for daily and monthly expenditures. They pose virtually no risk as an investment, and their interest rates are quite low. The main reason why people use this asset class is because it provides people with the most transactional freedom as compared to any other type of investment. The biggest problem with this type of investment is that it does not account for inflation. The money you invest in cash and cash equivalents is going to grow at a safe, but standard and minimal rate. Different banks offer different interest rates, but they usually do not exceed 4-7% annually.
The equity asset class includes stocks, shares, or buying into various business ventures through other means such as mutual funds. In the last few years, this asset class has grown immensely in popularity because it can be a short term and long term investment option with high returns. The risks of trading in the short term investment equity market are quite high, but so are their profit margins. Investment in long term equity normally gains the highest returns for the investor. Long term investments are anywhere over a year of holding the investment in equity, but investors normally recommend holding out for at least 10 to 20 years to see noticeably positive returns on their investment.
Fixed income assets are quite similar to the cash and cash equivalent assets. The main point of difference is that you don’t have as easy of an access to this money as you would with the cash or cash equivalent options in terms of transactional capability. The popular types of fixed income assets include government/corporate bonds, fixed deposits and provident funds. Again, similar to the cash equivalent assets, they are not inflation-proof, which means your funds will grow at a steady rate, regardless of the rate of inflation. They have a higher annual interest rate as compared to the cash and cash equivalent asset class options because the banks use this money to provide other banks with the permission to borrow the money you have deposited from you in exchange of a total guarantee of safety of your capital investment.
Real estate assets are investments in different types of properties. These are tangible long term investments that rely on the real estate market (locality, growth in population, and other market factors) in order to be successful or unsuccessful investments. Real estate investments are generally considered to be long term investments because they will only appreciate in value over a long period of time. Some popular real estate investment options include apartments, housing buildings, commercial buildings, office spaces, etc. The property owner can lease the acquired asset to others who are in need of a space and it can give them sustained long-term revenue before (or if) they choose to sell in the future.
Commodity-based assets include investments in gold, silver, precious stones, or even any other type of goods that can be traded. Some other types of commodities include crops, petroleum, oil, and more. Most commodities do not fall under the long term investment asset class because they are meant to be traded, such as petroleum, oil, and crops. Some commodities can be long term investments such as gold and silver because they are not perishable commodities and they can appreciate in value over time.
Investments in art, cryptocurrencies, hedge funds, and more are considered to be alternative investment options. They are extremely hard to liquidate and come with a high risk-high return investment opportunity. These types of investments are generally owned by high net worth individuals because they are quite costly investments to make, and they come with extremely high risks. They have a complex structure in terms of liquidation and rules and regulations, which is why it is not a sensible investment option for those who do not have large sums of money they would like to invest.
Derivative assets are those that come with a financial security based on the type of underlying assets that are being used for investment. These underlying assets could be shares, bonds, commodities, and more. The price of a derivatives asset is based on the price of the underlying assets, and on its own, the derivatives investment option has no value.
To reiterate our former point, you should always invest in a number of asset classes you are comfortable with. Since different asset classes come with different sets of risks and are subject to different environmental or market risks, they offer more financial security to the investor as compared to making investments in the same asset class.
Speak to your investment advisor or financial planner before you start investing in any of the asset classes mentioned above. They will help you make sound financial decisions based on their expertise that will allow you to reap the highest rewards on your investment. They also take your current financial status, your risk appetite, your comfort and your return rate expectancy into consideration before coming up with a plan to build your portfolio.
Thank you for reading.