When setting out to achieve their financial goals, an investor needs tools. There’s a vast universe available to investors today—from real estate to crypto—but mostly they all fall into broad categories known as asset classes.
Investors can benefit by holding a variety of asset classes to help achieve diversification, which is important in helping to control risk while (hopefully) maximizing returns.
What is an asset class?
At its simplest, an asset class is a group of investments that share similar characteristics, tend to react in much the same way to economic events, and are bought, sold, and regulated in a similar fashion. Some assets are more volatile than others, but have the potential for higher returns. Assets classes can move in tandem or in opposite directions, a feature that can help limit the impact that market volatility has on an investment portfolio.
The six most common asset classes
Six major asset classes cover the majority of investment options, though these are typically sliced and diced into an array of narrower categories called subclasses. The main classes are:
- Stocks, also known as equities, represent ownership pieces of publicly traded companies that change hands on a stock market. These can be large or small, domestic or foreign, and generally belong to an industry like utilities, technology or finance—all subclasses that can be further divided by characteristics like profit growth, price, valuation, or dividends.
- Bonds, sometimes known as fixed-income investments, are loans packaged into easily traded slices. Most pay set interest rates and mature at a future date, at which point the original principal is repaid. Bonds are issued by corporations, national governments, agencies, states and municipalities. Interest paid on different subclasses of bonds may be taxed differently, or even be exempt from taxation. Other bond subclasses are determined by credit ratings and maturities, which affect how prices react to changes in interest rates.
- Cash includes the paper bills in our wallets as well as what is stashed electronically in our bank accounts. It also denotes super safe investments like three-month Treasuries or other short-term securities such as those held in money market mutual funds. These assets are known as cash equivalents.
- Commodities are raw materials that are bought and sold via contracts on futures exchanges, although specialized mutual funds hold them too. Commodity subclasses include gold, oil, cotton, and even frozen orange juice.
- Real estate includes not just the family home, but big commercial and residential properties, pools of which can be bought through public companies known as real estate investment trusts (REITs).
- Alternative investments are those that don’t fit neatly into the other five categories. It includes funds that invest using techniques and strategies that set them apart. Hedge funds buy stocks and bonds, but also use strategies to profit if they fall. Venture capital invests in private start-ups, hoping they will flourish. Leveraged-buyout and private-equity firms use debt to takeover public companies and later sell them, sometimes at a steep mark-up.
Historical performance of asset classes
Depending on the circumstances, asset prices may either track each other or react very differently to the same economic developments.
In a period of robust economic growth, falling interest rates and low inflation, both stocks and bonds tend to perform well. When asset prices move in lock step, market experts call them correlated. But the price of gold, viewed as a hedge against inflation, is likely to fall in such an environment. When assets move in opposite directions, they have negative correlation.
That leads to some different returns.
In the first quarter of 2020, the coronavirus pandemic hit the U.S. Investors panicked as infection rates soared, businesses shuttered and the Federal Reserve cut its lending rate and bought back billions of dollars in government and other bonds in an effort to stimulate the economy. Here’s what happened: Stocks dropped 19.58% in the quarter, while bonds gained 3.5%, moving in opposite directions. Hedge funds, meanwhile, an alternative subasset, were in between, losing 11.55%.
One result of such short-term disparities is that long-term returns generated by different asset classes vary too. Indeed, studies show that asset allocation—not stock, bond, or fund selection—accounts for more than 90% of the differences in portfolio performance over time.
For example, during the 10 years that ended in July 2020, a period of low rates and low inflation, U.S. stocks delivered an average annual inflation-adjusted return of 10.46%. Bonds, meanwhile, generated annualized gains of less than a third of that—3.06%. Mostly because the interest earned on money sitting in bank accounts was so low, the little inflation that existed led to a negative return of 1.06% on cash. Commodities as a class were an even bigger losing bet over the decade, mostly because of cratering oil prices, with a negative annual return of 9.52%.
Looking at such returns, investors might wonder why not just plop all of their money into stocks. It’s a reasonable question.
First, though stocks have beaten bonds over the long term, they may lag for years or more. According to Deutsche Bank, since 1929 the inflation-adjusted return of stocks has trailed those of both bonds and cash in three out of nine decades—1930-1939, 1970-1979, and 2000-2009.
Second, many experts believe that investors who spread their money among asset classes are more likely to stay invested than those betting on stocks alone. Panic-selling in the midst of big stock-market sell offs like the 48.6% peak-to-trough drop during the 2008-09 financial crisis prompted many to cash out near the market nadir. The many who failed to reinvest missed out on the robust rebound that followed.
A 2021 Morningstar study shows fund investors sacrificed one sixth of their returns for the 10 years ended in 2020 by such poor market timing. That’s money left on the table.
How do diversification and risk tolerance play a role in asset classes?
Diversification among asset classes may be one way to smooth out price swings in investors’ portfolios, tempering downdrafts. The opposite can also hold true in that diversification may dampen upside performance if one particular asset class takes off.
Many investors search for a perfect asset mix. The right allocation, however, depends on many factors, including an investor’s time frame, risk tolerance, and appetite for returns.
Generally, the riskier the asset class, measured by how much prices vary over a set period, the higher the returns. Stocks are riskier than bonds which are riskier than cash. Real estate, commodities, and alternatives generally fall within that spectrum.
Selecting which asset classes to hold, and how much of each depends on any number of factors. Younger investors typically have a relatively high risk tolerance because they have more time to recover from losses. They may be able to better afford keeping a larger portion of their money in volatile and potentially higher earning asset classes like stocks. A young investor could potentially take the risk of holding as much as 80% of their assets in stocks, versus 10% in bonds, 5% in other asset classes and 5% in cash, which could be used to invest opportunistically if markets decline.
As investors age, they tend to shift how much of each asset class they hold in an effort to reduce investment risk. That means lowering the amount of equities held in a portfolio and raising the amount devoted to bonds and cash. By retirement, an investor might have only 50% of their assets in stocks, with most of the rest in bonds, and enough cash to meet living expenses or emergencies. Other assets, such as real estate, commodities, and alternatives, might also have a small place in an older investor’s portfolio.
The bottom line
Building wealth depends on apportioning money among various asset classes, an important way to achieve an investment diversification strategy. The goal is to help control risk while also maximizing returns. Although there are tradeoffs—limiting downside risk also means forsaking the potential for big gains—spreading a portfolio over the various asset classes can help an investor build wealth over the long term.