As you build your portfolio, it is important to be strategic about which asset types you intend to allocate funds to. From company stocks to bonds and precious metals, today's financial market offers a wide range of investment products, each possessing attractive characteristics tailored to specific investor goals and preferences. This is where having a solid understanding of the asset classification system becomes crucial.  

Asset classes are groups of investments with similar characteristics and governing regulations. Each asset class varies in risk and return potential and can contribute to a balanced and well-diversified portfolio.

Here is a brief lesson on the major asset classes in the current global financial market and the role they play in your portfolio:

What are the Major Asset Classes?

Historically, there have been three major asset classes, including equities (company ownership), fixed income (bonds and treasuries), and cash equivalents (treasury bills and commercial paper). However, it's important to note that cash equivalents are also a form of fixed-income investments, with the major difference being that they are short-term (90 days or less) and highly liquid.

Any investment that does not belong to the three traditional asset classes (stocks, bonds, or cash) is grouped in the alternative assets class. However, many alternatives are increasingly becoming preferred by retail investors. For example, there is a growing market for commodities (such as oil and metals) and currencies (including the Dollar, Pound, Yen, etc.), making them important asset classes in today's financial system. Alongside these, there are other alternative classes such as real estate, private equity, and cryptocurrencies.

Investing in Equities

Assets in the equities class are typically company shares also known as stocks. Owning equities means you are purchasing a stake in a company, benefiting from its profitability and growth, but also participating in possible losses. There are several ways to include equities in your portfolio. You can directly invest in stocks through the stock exchange or buy mutual funds that provide exposure to equities.

The value of equities is directly driven by company performance and investor demand, with equity investors making money through either:

1. Receiving profit dividends from the company
2. Or selling shares previously bought at a lower price

The equities market is highly volatile as share prices can fluctuate, and even dramatically drop in value in response to unprecedented fundamental or macroeconomic factors. However, with patience, a long-term approach, and expert stock-picking skills, equity investing is highly rewarding and an effective way to build wealth.

Investing in Fixed Income:

The fixed-income class comprises a wide range of assets that pay investors fixed interest on their principal investment until the specified maturity date. Some common fixed-income securities include Treasury bills, government bonds, corporate bonds, money market funds, and certificates of deposit.

Unlike equities, where income can change based on company performance and investor demand, the payments received for fixed-income assets remain the same throughout the investment period. Similar to equities, investors can choose to sell their fixed-income securities for a profit on the market if the interest rate environment is favorable.

While returns on fixed-income assets are predetermined and not affected by price volatility, the primary risk in fixed-income investments is the potential for issuing corporations to default on their loans and fail to make payments.

Another factor that can affect the value of a fixed-income asset is when the prevailing interest rate in the market rises, leading to the issuance of new bonds with higher interest payments. This can cause a decrease in the resale value of currently owned fixed-income assets, which may be a concern if you own long-term assets such as a 10-year bond.

While fixed-income investing may not offer the same return potential as equities, it is an excellent choice if your goal is to generate a steady income or simply balance risk in your portfolio.

Investing in Commodities:

Commodity investing is an alternative to traditional asset classes (equities, bonds, and cash). It involves owning and trading raw materials that can be transformed into other goods and services. Examples include metals like copper and aluminum, energy resources such as gasoline and natural gas, and agricultural goods like grains and livestock. Commodities are essential resources used to drive the economy, contributing to the production of everything we consume, from computers and smartphones to buildings and roads, as well as packaged foods and apparel. Precious metals like gold and silver also fall under the category of commodities.

Commodity investing can take three forms:

1. Physical ownership and trading of raw materials for profit.

2. Investing in commodity futures contracts.

3. Buying shares in companies that produce commodities.

The value of commodity investments is driven by supply and demand, making it a highly volatile asset class influenced by various factors, including weather, market fluctuations, regulatory changes, and political and financial factors.

Despite these underlying risks, commodity investing can be successful as part of a diversified portfolio. Commodities represent a highly defensive sector that tends to perform well in an inflationary environment. Furthermore, commodities have a low correlation with traditional assets, making them an effective way to diversify a portfolio's exposure.

Investing in Currencies

Currency investing involves trading one currency for another on the foreign exchange market to capitalise on currency volatility. Much like stock trading, forex traders analyze and predict market movements for a specific currency while establishing trading positions for optimal returns.

Currencies represent a relatively new asset class, and an ongoing debate exists about whether it should truly be considered an asset class, as it lacks intrinsic or standalone value that can be measured by fundamental economic data or a long-term risk premium for investors to capture. However, it's worth noting that the currency trading market boasts over $5 trillion in global transactions daily.

Investing in currencies can take various forms, including:

1. Directly trading currencies through a standard Forex account.

2. Buying cash equivalents like money market funds or certificates of deposit in specific countries.

3. Investing in mutual funds with exposure to foreign government bonds.

Other Alternative Investments

Investing in alternative investments is characterised by a less regulated environment and a higher degree of risk. Therefore, it is a class best suited to institutional investors and high-net-worth individuals. Common alternatives include:

Real Estate:

This involves investing in physical properties or property-based securities such as real estate investment trusts (REITs). Real estate investors can generate income from capital appreciation on their properties or through rental arrangements that provide stable cash flow.

Private Equity:

Although still a form of equity investing, private equity is an alternative for investors who seek company ownership through avenues other than buying stocks on the open market. Private equity investors put their money into start-ups (venture capital) and maturing companies (growth capital). Sometimes, they buy public companies and take them private.

Cryptocurrency:

An emerging alternative investment is cryptocurrency, a digital currency like Bitcoin and Ethereum that operates outside the control of a government or financial institution. Investing in cryptocurrency is very risky as the market is more volatile than traditional assets like stocks. Cryptocurrency investing can involve buying and holding a cryptocurrency to resell for a profit or investing in a company with a business focus on cryptocurrency. Cryptocurrency investing is also lightly regulated, making investors more susceptible to scams.

How Each Asset Class Can Contribute to Your Portfolio

Ensuring Long-term Growth Potential

Equities offer the best opportunities if your investment goal is to generate significant returns over a long-term investment horizon. Start by searching for value stocks and growth stocks worth adding to your portfolio.

Generating Stable Income

High-yield bonds and other fixed-income assets are the right investment types for generating predictable returns. However, high-dividend stocks can also contribute both long-term growth and steady income to your portfolio.

Hedging Against Inflation

In a high-inflation environment, commodities keep up with rising prices, making this asset class a solid recommendation for your portfolio if you wish to beat the impact of inflation. Another great option is inflation-adjusted bonds such as Treasury Inflation-Protected Securities, which are also fixed-income assets with the principal and interest payments adjusted for inflation.

Surviving Economic Recession

During recessions and economic declines, the stock market underperforms. However, certain safe-haven assets such as gold have a low correlation with the stock market and provide an option for investors to preserve the value of their portfolio from significant loss. Government bonds and cash also present low volatility risk in a recessionary environment and can be great options as well.

Asset class categorisation is used to understand various investments and how they can complement each other to diversify risk and returns in a portfolio. As you build your portfolio, you can seek the help of a financial advisor to combine assets from different asset classes and create a solid portfolio.

You can also analyse investments in various asset classes ranging from equities to bonds, real estate and cryptocurrency on Anahit. Try it today by creating a free account.