Understanding asset classes is essential if investors are to construct portfolios that match their goals and appetites for risk. We provide a definition below, share some key types of asset classes and discuss how they fit within a portfolio.
What are asset classes?
Assets – both financial and real – fall into certain groupings, known as asset classes.
Asset class definitions each include a broad range of asset types, but the assets within each class do still usually share certain similarities, such as their legal structures and how they react to certain market conditions.
For example, ‘equities’ includes shares in companies that differ across a broad range of sizes (e.g. small, mid and large capitalised companies), industrial sectors (financials, healthcare, technology) and operate in different geographies. But the basis of their legal structures is generally the same, i.e. giving the right to part-ownership in a company and its profits. Also, bonds can vary along the same lines as equities, but their prices will generally fall in response to a rise in market interest rates.
So what are the different asset classes?
The main asset classes
There are three main asset classes, including equities, bonds and cash.
Equities: An equity gives a holder the legal right to a share in the ownership of a company and a portion of its profits. Equities can be the most volatile of the asset classes but they can also deliver some of the strongest returns if they are held for a sufficient length of time. For a better understanding of equities, see here.
Bonds: These are IOUs issued by governments and companies, with the promise to pay interest (the coupon) and return the loan value at the end of a set term, or maturity. The amount of interest payable will depend on how creditworthy the borrower is. For more information, see: What is a bond?
Cash: This normally refers to bank and building society accounts although there are also ‘cash’ funds that loan investors’ money on the open market.
What are the other asset classes?
Categories outside of the main asset classes are known as alternative asset classes. These include, for example:
Real estate: Owning your home is an investment in real estate but commercial properties also offer investment opportunities. Because of the large sums involved, these are usually accessed via a fund that pools investors’ resources and which have a professional manager who constructs a portfolio of assets. Real estate falls into a category known as ‘real assets’. For more information, see What are real assets?
Commodities: Physical commodities include oil, precious and base metals and soft agricultural products such as coffee, cocoa and wheat. There are specialist funds that invest in this asset class by storing physical commodities or by using financial instruments known as derivatives that track their prices. For more information, see our What is a commodity?
Private equity: This is investment in private companies, i.e. those that are not listed on public stock markets. Such companies are often smaller and have yet to be floated on the stock exchange, although large public companies are sometimes de-listed and taken private. Some investors will own private companies but they can also invest in this asset class via specialist funds.
Using types of asset classes in portfolios
When you invest, you will put your money into one or more of the asset classes. The choice of asset classes is a key decision for investors because they carry very different levels of potential risk and return, even before the risk/returns within each asset class can be weighed up. Equities and bonds are higher risk assets than cash but they also offer the potential for much higher returns, for example.
Investing across the different asset classes is a key element of diversifying portfolios. This is because there is usually little or no correlation in their respective performances. The differing strengths and weaknesses of the asset classes means they should perform differently in various market situations. In this way it is possible to construct portfolios ‘for all seasons’. For example, in 2021, UK and US equities delivered positive returns as the economy recovered after the Covid lockdown, but UK bonds saw negative returns as the interest rate cycle turned upwards.
It is very important for investors to understand the different types of asset classes and how their portfolios are allocated to them. They should, for example, examine to which asset class or classes an investment fund is exposed, which should be outlined in the fund’s literature. By understanding the risk-rewards implied by this, investors can allocate their portfolios to match their investment goals. For more information, see What is diversification?
