Building a great portfolio can be compared to cooking a great dish: It’s all about balance, using the right mixture of ingredients. In investing, these ingredients are called asset classes.
Many asset classes are non-correlated to each other, meaning the performance of one doesn’t impact the performance of the other, and they often move in entirely different ways. One asset class may be up this year while the others remain stagnant, but resist the urge to put all your money in one place. When one asset starts to decline, owning a mix of others can help cushion the financial blow.
What is an asset class?
An asset class is a group of investments that are similar or perform similarly. Broadly, there are three main asset classes, and within those are other subcategories.
Also known as stocks, equities represent shares of ownership in a company.
Pros and cons. When held for the long-term, stocks typically offer the best chance of capital appreciation. That’s why they are often the primary asset class in a portfolio. Since 1929, the Standard & Poor’s 500 index of stocks has returned an average 9.65% per year. During shorter periods, however, stock fluctuations can make some investors anxious. Historically, stocks lose money on average about one in every three years. Over time, however, they tend to produce steady returns.
Subcategories. One way to reduce the risk of a stock portfolio is to diversify your stock holding. You can break equities into different subgroups, according to:
Style: In general, stocks can be sorted into a few large categories.
- Growth stocks are shares of companies that may seem expensive compared to earnings but have the potential to grow into their valuations.
- Value stocks are those that investors think are inexpensive compared to valuation.
- Income stocks are shares of companies that pay a consistent dividend. So-called “blue chip” stocks are shares of large-growth companies that pay dividends.
Size: Otherwise known as market capitalization or market cap, the size of a company in your stock portfolio can have an impact on its risk profile.
- Large cap: Companies generally worth $10 billion or more. These stocks generally move the market, and are represented by the S&P 500 Index.
- Mid cap: Companies worth between $2 billion and $10 billion.
- Small cap: Companies are generally worth between $300 million and $2 billion. This is a large market filled with incredible new ventures, as well as companies that won’t make it in the long run.
Country: Another way to group stocks is according to where the companies are based:
- Domestic stocks are shares of U.S. based companies.
- Foreign or international stocks are shares of non-U.S. based companies.
- Emerging market stocks are shares of companies based in countries or regions with economies that are beginning to develop or advance.
2. Fixed income
Also known as bonds, these represent shares of company or government debt, which pay a rate of interest to investors.
Pros and cons. Bonds are designed to provide a reliable stream of income and pay back the invested principal once the bond has matured. Most investors hold bonds in their portfolios as a way to preserve capital or balance the risk of stock holdings. There are, however, plenty of risks involved with owning bonds, including issuer-default or credit risk, interest rate and inflation risk, even liquidity risk if you can’t sell the bond. Learn more about bonds here.
Subcategories. Investors often buy bonds for their creditworthiness, tax advantages or income potential. Different types of bonds include:
Government bonds: Also known as Treasuries, these issues are backed by the full faith and credit of the U.S. government. They come in a few different forms: Treasury bills for shorter-term investors and notes and bonds for longer term. Treasury Inflation Protected Securities (TIPS) are notes or bonds with dividends that track inflation according to the Consumer Price Index.
Municipal bonds: “Munis” are issued by municipalities, such as cities and states. Munis can include revenue bonds issued to build a project, conduit munis issued on behalf of a regional non-profit, or general obligation bonds. Interest paid by munis may be free from federal as well as state or local tax.
Corporate bonds: Issued by public corporations as well as private companies, these are generally considered “investment grade,” which means companies with high credit ratings offer them according to one of the major rating agencies (Moody’s, S&P or Fitch). The highest rating is AAA, and bonds become riskier when ratings are around BBB or below.
High yield: “Junk” bonds are issued by companies with questionable credit ratings below BBB.
Foreign bonds: Issued by foreign entities and sold in the domestic market. Examples include bulldog bonds from England or samurai bonds from Japan.
Certificates of Deposit (CDs): Not bonds but savings accounts, CDs do pay a fixed rate of return for a specified period. These are considered very low-risk investments, and if you purchase a CD through a federally insured bank, the investment in a CD is insured up to $250,000.
3. Cash and cash equivalents
Everyone is familiar with cash; cash equivalents are similar places to keep money in the short term.
Pros and cons. Cash is liquid, which is handy when you need it for a big purchase or to make a move in your investment portfolio. Cash equivalents are similar and typically come at very low risk (but they are not entirely without risk). Cash usually does not keep pace with inflation, so smaller amounts of money are best.
Money market funds: Mutual funds you can draw checks or cash from. They invest in short-term debt to earn a slight rate of return.
Short-term government bonds: Liquid bond investments to help generate a slight rate of return.
Treasury bills: Short-term government debt issues.
Additional asset classes
Investment real estate includes holdings outside of your primary residence.
Pros and Cons. Real estate does not tend to move with other investment markets, and has produced steady dividends as well as capital gains.
Real Estate Investment Trusts: REITs are the easiest way for most investors to participate in real estate. They are shares of ownership in real estate companies that operate many income-producing properties. Publicly traded REITs are more liquid and transparent than those that are not publicly traded.
These are basic materials that, in bulk, don’t differ much from provider to provider. They trade on their own market as future contracts: agreements to buy or sell a certain amount of a commodity at a given price on a future date. Most investors try to get out before the expiration, lest they wind up owners of bulk commodities.
Pros and cons. Commodities don’t move in conjunction with stock and bond markets, and investors tend to find safety in them during market downturns. On the other hand, commodities can be complicated; the markets are volatile and not heavily regulated and it’s easy for the average investor to get burned.
Subcategories. Commodities include goods such as metals, oil, livestock and agricultural products, as well as more conceptual items for trade, such as bandwidth. A commodities exchange-traded fund (ETF) that spreads the risk among different subgroups may be a simpler option for non-experts.
The bottom line
Spreading your investment dollars around to hit different asset classes is called diversification. With an understanding of asset class types, you can create an asset allocation in line with your investment time horizon, and to suit your personal risk tolerance.