Oftentimes, when a subject is too broad and complex, people tend to classify it into “groups” to simplify identification, observation and analysis. Take for example the entire animal kingdom that you and I are both apart of (unless, of course, you’re an alien, yikes!). There are a lot of different creatures in the animal kingdom and observing them as a whole could cause a lot of headaches!
Thankfully, there’s a thing called taxonomy that groups animals with similar characteristics and stratifies the different classes of animals. Now we know how to differentiate a mammal from a reptile, an amphibian from a bird or a mollusk from a fish. Okay, you get the picture. We’re not gonna play your science teacher anymore.
Like the animal kingdom, investing is also a very broad and complex topic. If you’ve read our previous articles, you might have already gathered by now that there are a lot of stratification and groupings going on in the world of investing.
Now, we’re going to discuss one type of classification of investments: Asset Classes.
What Are Asset Classes?
Asset classes are basically a group of investment securities that demonstrate similar financial characteristics. Knowing the different asset classes is key to diversifying your portfolio and maximizing your investment returns.
Please read The First Thing You Need to Know About Diversification before proceeding.
What Are the Major Types of Asset Classes?
- Stocks (Equities) – Stocks or shares represent ownership in a company. If you hold a stock of, say, Alphabet, you are considered a part-owner of that company to the extent of the stocks you hold. Stocks are the most volatile of asset classes in the short term but have proven to be the most profitable in the longer term. Stocks are considered to be high risk – high return investments.
- Fixed-Income – Fixed income assets include bonds, mortgages, certificates of deposit and money market instruments. The most common type of fixed-income investment is a bond. Bonds are debt investments in which the investor is essentially lending money to a company or entity. Bonds earn through fixed or floating interest rates, thus making them more stable than stocks. Most fixed-income investments are considered to be of low to moderate risk with moderate returns.
- Cash and Cash Equivalents – Cash and cash equivalents include the money you deposit in your savings account, checking account and term deposits. These are considered to be low risk – low return investments.
- Alternative Investments – Alternative investments basically are investments outside of three aforementioned traditional assets. Usually, alternative investment assets are held by institutional investors or high-net-worth individuals due to their complex nature, relative lack of liquidity and limited regulations. Below are some types of alternative investments.
- Properties – This category includes real assets (e.g., physical or tangible properties) such as real estate (residential, commercial and industrial properties) and agriculture land being held to generate income.
- Commodities – Commodities are tangible basic goods used in commerce that have been grown or extracted from their natural state and developed to a minimum grade to be sold in the marketplace. This includes oil, gas, gold, rice, coffee beans, grains, etc.
- Currencies – This category, as the name suggests, includes investments in specific currencies and generating income through currency trading or value appreciation.
- Venture Capital – Venture capital is essentially funding provided by investors to new or “start-up” companies with perceived long-term growth potential. The accompanying risk tends to lean on the higher side, but the potential for returns may also be extremely high.
- Hedge Funds – Hedge funds use “pooled funds” (e.g., a collection of investments from individual investors) that may use different investment strategies to generate a return. The investment strategy used for the hedge fund depends on the various investment styles, which include a unique combination of risks and opportunities.
5 Steps to the Optimal Asset Allocation
Step 1: First, you must determine your risk tolerance and return objectives. In our article about understanding your risk tolerance, we have outlined several factors you should consider when determining how much investment risk you are comfortable with. These factors include age, net worth, investment objectives and experience.
Step 2: Once you’ve determined your risk tolerance and objectives, you have to find the right asset allocation. To be able to do this, you must be cognizant of the level of risks involved in each asset class. The common rule of thumb is to subtract your age from 110 and whatever figure you get would be the percentage you allocate to stocks. For example, if you’re 30 years old, the percentage of stocks in your portfolio ideally should be 80% (110 minus 30). Keep in mind, this is a simplified rule-of-thumb approach to get you thinking in the appropriate frame of mind.
This relates to diversification. Again, make sure to read the article.
Step 3: Decide whether you want to select and manage your investments directly or pay a professional to do it. It all comes down to how confident and gutsy you are with your “mixing” skills. Read our 3 pros and 3 cons of hiring a financial adviser here. If you’re doing it yourself, you’ll need to select individual securities for each asset class.
Step 4: Keep calm and hands off your investments! It could be very tempting to sell some stocks and other investments once they start going down or go up. This is a common investing mistake. But here’s some unsolicited advice, my friend – DON’T. If you’ve spent a good time researching on the asset classes, the companies you’re investing in and what mix would be right for you, then don’t panic. Observe and analyze what really is going on because you may be reacting like there is a hurricane when it’s only a drizzle.
Step 5: Reevaluate and re-balance your portfolio. Essentially, redo steps 1 to 4 on a regular basis; perhaps a few times a year. The reason for this is to make sure you’re still on track with your goals and you adjust anything that’s necessary if your circumstances have changed. For example, if you have a child on the way, some aspects of the IPS will need to be revised.