TL;DR
- When you are investing, it is important to be diversified. In other words, you want to invest in a variety of types of investments. These types of investments are called asset classes. You can also have a diversity of investments within those asset classes.
- Diversification is important because it shields you from losing a lot of money if a particular investment does poorly. It also increases your chances of earning money if something does unexpectedly well.
- Unless you have insider info, people rarely know if something will do well or poorly in the future.
- The 5 main types of asset classes are equities/stocks, fixed income/bonds, cash/cash equivalents, real estate, and commodities (including cryptocurrency). The risks and historical returns of each are detailed below.
- You can diversify your stocks in terms of the size, location, and industry/sector of the company, as well as how over- or under-valued the company is.
- Index funds and target date funds tend to be the easiest, lowest cost ways of diversifying your investments.
What are asset classes?
There aren’t a whole lot of thrilling conversations that center around asset classes. Just the term itself sounds pretty boring. But asset classes are important to understand in order to make money. And that is pretty exciting!
So what are asset classes? Asset classes are groups of investments that tend to earn money in similar ways. They also have similar rules and regulations surrounding them. Key examples of asset classes include stocks, bonds, cash and cash equivalents like money market accounts, real estate, and commodities (including cryptocurrency).
Types of Asset Classes
What are the types of classes? There are 5 main asset classes. I go into each individually below. After that, I turn to the benefits of understanding these types of asset classes.
Stocks/Equities
The terms stocks and equities are generally used interchangeably. Basically, when you buy stocks, you purchase shares in a company. As a result, the success of your investment is based on how well the company is doing. Similarly, you might invest in index funds, mutual funds, or exchange-traded funds (ETF). These funds are pools of stocks from a large number of companies. For example, an index fund based on the S&P500 includes stocks from the 500 largest companies in the U.S. The performance of your investment will therefore depend on the performance of those companies cumulatively.
The past performance of stocks depends on the stock in question. However, the S&P500 has returned 10% per year over the past 100 years. In 70% of those years, the stock market went up according to NerdWallet. However, in 30% of years it went down, sometimes considerably.
There are risks to investing in stocks. Because the success of your investment depends on how well a company or companies are doing, your investment return is not guaranteed. It can go down or up depending on market conditions. Additionally, investing in individual stocks (like Apple stock or Tesla stock) involves higher risk than investing in a pool of investments like an index fund or ETF. However, over the long term, index funds and ETFs have earned reliable returns.
Finally, some kinds of investing are not very liquid. For example, if you invest in stocks within your 401K, your money is pretty stuck there. If you want your money soon, it’s best to put your money in alternative investments that are liquid (allow you to take your money in and out easily).
Fixed-Income Securities or Investments
Fixed income investments pay a fixed amount of interest on a fixed schedule. Bonds and treasury bills are popular examples of fixed-income investments. These types of investments are usually issued because a company needs money. Consequently, you, as the investor, are loaning some of that money in return for interest.
Returns vary depending on the type of bonds you have. However, the long-term government bond index has had an average annual return of 5.59%. Shorter-term bonds tend to have lower returns. High-yield bonds have higher returns, but they also come with a higher level of risk.
Fixed-income investments can be good options for individuals with low risk tolerance. Indeed, if you are investing in government bonds, you lose your money if the country you’re investing in collapses. If you’re investing in corporate bonds, you lose your money if the company defaults and is unable to pay its loans. Generally, these risks are quite low unless you’ve picked a very precarious company/country to invest in. The bigger risk with fixed income investments is that the return is lower than inflation. Consequently, in real terms, you’re not earning money.
Cash or Cash Equivalents
Cash investments offer an interest return (like bonds). However, they are generally very liquid assets. In other words, you can quickly convert them to cash. Examples of cash investments are money market funds, high yield savings accounts (HYSAs), and certificates of deposit (CDs).
Generally, these kinds of investments have only earned about 1% a year. Consequently, their biggest risk is that they don’t keep up with inflation well. That being said, they’ve earned higher returns in recent years given high interest rates in 2022 and 2023. Once interest rates decline again, the returns on cash equivalents will also likely go down.
Nevertheless, cash and cash equivalents are helpful places to put your money for short-term goals that are less than 5 years out. They offer a safe space to put your money and earn a small return. They are not as great, however, for long term financial goals.
Real Estate
Investing in real estate can involve purchasing a property and selling or renting it for a return. Alternatively, it could also mean investing in Real Estate Investment Trusts (REITs) or Real Estate Investment Groups (REIGs) without purchasing property.
Real estate investments have similar returns to stocks. Based on past performance, they’ve returned about 7-10% on average. However, real estate investments have different levels of risk and reward depending on property types (single-family homes vs. commercial vs. apartments), location, how long you hold the property, etc.
Similar to the stock market, the success of your investment depends on the real estate market and economic conditions. It also depends on how much you have to pay for phantom costs (like maintenance) and selling costs. Real estate can be a good longer-term investment and you may have some control over returns by making upgrades to a property. However, in the shorter-term, real estate investments involve significant risk.
Commodities
Commodities are unprocessed goods and materials (like gold and wheat) that can be used or sold. They also include things like artwork and cryptocurrency like Bitcoin. Basically commodities get their value from demand for that product exceeding the supply of that product. Commodities do not, themselves produce value (except maybe in the case of something like cows that do produce milk).
The returns for commodities vary a ton depending on what kind of commodity we’re talking about. Consequently, it’s sort of irresponsible to put an average here. Over the past 10 years, however, the S&P’s Commodity Index has returned –0.67%
Additionally, the risks of commodities are quite large. Again, the returns largely depend on demand outstripping supply, which itself depends on the economy, the particular market, and consumer perception. Think about how demand for Bitcoin changed dramatically in the face of recent scandals. Or toilet paper being a commodity during COVID. Long-term, there’s very little sense of where commodities will go in terms of producing value. Commodities can be investments for “play money,” but should never be something you bank on.
Why are asset classes important?
Now that we’ve gone over the types of asset classes, how are they helpful for you?
Asset Classes Protect You Against Market Volatility
You’ve probably heard the phrase “don’t put all your eggs in one basket,” despite the fact that most of us will never put any eggs in baskets unless they’re Easter eggs. You may have also heard that phrase applied to the stock market.
That phrase gets at the idea that if you invest, you want your investments to be diversified. In other words, you want to have a lot of different types of investments so that you don’t tank if one investment suddenly does poorly. For example, cryptocurrency is super volatile. You could suddenly lose a huge chunk of your investment portfolio if it goes down, as it has in the past. Having different types of investments protects you against that market volatility.
On a more positive note, you also want different types of investments because then you have a better chance of cashing in when something does unexpectedly well.
Different asset classes are the big baskets you can spread your eggs into. Within those asset classes you can further diversify with different types of stocks, bonds, real estate, etc. It’s sort of like diversifying the baskets and then the eggs that you put within those baskets.
To sum up, you want to diversify your investments to have a safer and more profitable investment portfolio. Understanding asset classes helps you do that.
Asset Classes Have Different Benefits and Costs
Additionally, different types of asset classes have different benefits and costs. For example, stocks and real estate tend to have high returns compared to the other types of asset classes. However, they’re also best for long-term investment strategies because of their volatility. In other words, because they move up and down in the short-term but move up in the long-term, you want to save these investments for financial goals that are 5+ years away.
In contrast, fixed-income investments and cash equivalents are very safe. Cash equivalents are also super liquid. They’re therefore great to include in your asset allocation if you have a low risk tolerance or want your money soon. At the same time, you likely don’t want to make them a central part of your investment strategy because they generally don’t beat inflation in the long-term.
Finally, commodities are the riskiest group of investments. You may want to include these alternative assets to take advantage of unique investment opportunities. At the same time, because of their risk level, you should aim to only invest money in them that you are okay with losing. You may also find it useful to speak with financial advisors about the risks of these assets.
Diversifying Stocks and Equities
Like I mentioned way back in the first section, you can diversify your baskets, but you can also diversify the eggs that go in those baskets with different types of stocks, bonds, real estate, etc. In this post, I focus on different types of stock investments. You can find a detailed assessment of different types of cash and cash equivalents in my post on How to Save For Any Goal.
When you invest, you can diversify in terms of a few different key things: the size of companies (small-cap stocks, medium-cap stocks, large-cap stocks), where those companies are located (i.e. different regions, countries, and continents), which industries or sectors those companies are in, and whether their company is considered over- or under-valued.
A note on terminology: the terms “small cap,” “medium cap,” and “large cap” sound confusing. However, you can replace the word “cap” with “company” to get a good idea of what those stocks represent.
If you are choosing stocks individually, you will want to think about how to have an investment portfolio with a wide range of investment assets that differ in these various ways. That’s pretty difficult (and expensive!) to do. Luckily, there is an easier way of creating a well-diversified portfolio that I’ll discuss below.
What does not count as diversification? Having your money at different companies. If you have your money in the same types of stocks at two different companies, that’s not diversification. That’s like saying you have a diversified dinner if you got a cheeseburger from McDonald’s and a cheeseburger from Burger King—you really just have two cheeseburgers.
The Simple Way to Diversify
It would cost so much money for individual investors to buy stocks in hundreds of companies with different qualities on the stock exchange. Luckily, there are index funds, mutual funds, and ETFs that make this way easier and cheaper to do. Index funds, mutual funds, and ETFs are pools of investments that generally fit into a certain category. As mentioned above, index funds based on the S&P500 include stocks from the 500 largest companies in the U.S. Similarly, the Russell 2000 index includes stocks from 2,000 smaller publicly-traded companies.
These index funds are well diversified because they include a large number of companies in different industries and locations. Consequently, investing in an index fund is an easy way of injecting a good amount of diversification into your investments. You can also invest in multiple index funds to further diversify—like invest in the S&P500 to get a lot of representation of large companies and then invest in Russell and/or Emerging Markets to get some representation of smaller companies and/or companies in a variety of countries.
A related easy way of diversifying your money is to invest in a target date fund. Target date funds take the year you expect to retire and, over time, move your investments from more aggressive assets (like stocks) to safer assets (like bonds). This means they have some diversity in terms of asset classes. The Target Date Funds at some financial institutions, like Vanguard, specifically invest in Index funds and so are pretty diversified in terms of investments within asset classes. If you invest in a Target Date Fund, make sure you know what goes into it and whether it’s diversified in a way that meets your financial objectives.
Final Thoughts on Asset Classes
The take home point is this: Having a variety of types of investments and having a variety of investments within those types is the best protection against an uncertain market and is your best bet at actually making money reliably over time. And more money and less stress is on all of our wishlists, right?
Remember that I’m not a financial advisor so make sure to consult with a professional financial advisor before making any decisions about how to spend or invest your money.
If you enjoyed this post, please consider liking, subscribing, or sharing with others! Interested in related content? Check out my posts on
- Saving for your goals
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- Your easy guide to opening an investment account
- Investing for retirement
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