Understanding asset classes and combining them is critical in building a lucrative investment portfolio. Asset classes are an essential part of the diversification strategy, which allows you to capture returns while managing the overall risk profile of your investment portfolio. Different asset classes have a different correlation to the overall financial market and other asset classes, so having various asset classes represented in your investment portfolio might cushion the value of your portfolio in a downturn as well as enhance your portfolio’s yield.
The whole asset universe is usually split between traditional and alternative asset classes.
Traditional asset classes
When you hear the word “investment”, we usually talk about traditional asset classes. There are three classic categories of traditional assets: cash, bonds, and stocks.
Cash and cash equivalents, as most liquid assets, include actual cash at hand and in a bank, as well as equivalents that can be easily converted to cash, such as money market instruments or short-term government bonds.
Bonds are a debt investment – the investor lends the money to the borrowers and is paid back at a fixed interest rate. There are many types of bonds, from high-quality government bonds to high-risk/high-return junk bonds.
Stocks are securities that represent ownership in a company – the investor buys a share in the company and gets his return via dividends or the appreciation of the stocks. Again, there are many types of stocks, from small-caps to large-caps, from value stocks to growth stocks.
Alternative asset classes
Alternative assets typically refer to investments outside the traditional asset classes listed above. The beauty of alternative assets is that they are less correlated with general financial markets, offering security in uncertain times and providing proper diversification. The most well-known alternative asset class is real estate, followed by venture capital and private equity. More exotic alternative assets include commodities, derivatives and collectables.
Real estate is land and everything that is permanently fixed to that land. Real estate is typically divided into residential, office, industrial, retail, and hospitality sectors.
Investors can make direct real estate investments by buying the specific real estate asset or indirectly via real estate crowdfunding or real investment funds.
Read more about the main characteristics of the real estate asset class here!
Venture capital is a high-risk, high-potential reward investment, usually coming from institutional and high-net-worth investors. Venture capital is invested in early-stage startups and small businesses with significant growth potential over the long term.
Private equity is the capital invested into private (e.g. unlisted) companies. While private equity investments have several similar characteristics to venture capital, private equity is usually invested in more established companies.
A commodity is either a natural resource or an agricultural product. The most well-known commodities are precious metals and energy products, and the more exotic ones are wheat, corn, soybeans or orange juice.
Collectables are items worth more than their non-collectable counterparts due to rarity or being in demand. Collectables include artwork, antiques, vintage wine and whisky, classic cars, watches, jewellery, stamps, and coins.
Achieving optimal asset allocation
Asset allocation refers to the mix of different asset classes in your investment portfolio. The process of determining which combination and proportions of asset classes to hold in your portfolio is a very personal one. The asset allocation that works best for you at any given point in your life will depend primarily on your time horizon and your ability to tolerate risk.
Your time horizon is the expected number of months, years, or decades you will be investing to achieve a particular financial goal. An investor with a longer time horizon may feel more comfortable taking on a riskier or more volatile investment because they can wait out slow economic cycles and the inevitable ups and downs of financial markets.
Risk tolerance is your ability and willingness to lose some or all of your original investment in exchange for greater potential returns. An aggressive investor, or one with a high-risk tolerance, is focused on achieving higher returns and is more likely to risk losing some money in the process. Conversely, a conservative investor favours investments that will preserve their original investment and is happy to accept much lower returns.
Risk versus Reward
All investments involve some degree of risk, and the risk and the reward are inextricably entwined. The reward for taking on risk is the potential for a greater investment return, and vice versa – if your risk tolerance is low, do not expect high returns from your investments.
- Equities, bonds and real estate are the three main asset classes, and they should be the foundation of all investment portfolios;
- Asset allocation is the key driver for determining the long term long-term return and riskiness of your investment portfolio.
- Optimal asset allocation depends mostly on your investment horizon and risk tolerance. The younger you are, the more risk you are able to bear and thus – equities and real estate should be the key asset classes in your investment portfolio. The older you become, the less risk you tolerate – thus, you should get rid of some equities and other higher-risk investments and replace them with fixed-income instruments.
In our next post, we will highlight the main reasons you should consider making real estate one of the main pillars of your investment portfolio.
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