When you make an investment, you are purchasing a share of an asset, like a company. But not all assets are the same. There are many different types of assets—that are grouped into asset classes—that you might choose to add to your portfolio.
Below, we define what an asset class is, walk through an overview of the most common asset classes you should know about, and explain the importance of using asset classes to help diversify your portfolio.
What is an asset class?
An asset class is simply a category or grouping of investments that are similar to each other—and different from assets in other classes—in key ways.
Generally speaking, all assets that fall into a specific asset class will:
- Be subject to the same laws and regulations
- Behave similarly on their respective markets
- Exhibit similar characteristics to one another (such as risk, liquidity profile, company profile, and potential for return)
- Perform similarly under specific economic conditions
It’s also important to note that asset classes can be further divided into more specific sub-asset classes. These sub-asset classes all share key characteristics of their parent asset class, while differing from other sub-asset classes. Large-Cap and Small-Cap stocks (large companies and smaller ones), for example, are two sub-asset classes that fall under the parent asset class of stocks.
Common Asset Classes
The most commonly-accepted asset classes include:
- Cash and Cash Equivalents
- Real Estate
Stocks allow an individual to purchase shares in a company and essentially become a partial owner of that business. They are bought, sold, and traded on exchanges and are often included in a variety of funds (including target-date funds, mutual funds, and ETFs).
Most people invest in stocks because they expect a return on their investment through dividends, the ability to sell their shares at a profit in the future or a mix of both.
This asset class can be subdivided into a number of sub-asset classes, including:
- Small-cap stocks
- Mid-cap stocks
- Large-cap stocks
- Domestic stocks
- International stocks
- Emerging market stocks
At their core, bonds are loans that an investor makes to a borrower—typically a government, agency, municipality, or corporate entity. In exchange for this loan, the borrower, also known as the bond issuer, promises to repay the face value of the loan—plus regular interest payments along the way. For this reason, bonds are typically purchased for income generation and stability in a portfolio.
A bond is initially purchased directly from an issuer in what’s known as the primary bond market. But bonds can also be bought and sold on a secondary market, where their value can fluctuate depending on a variety of factors.
Like stocks, bonds can be further subdivided. Typically, this is done according to types of bonds, which include:
- Corporate bonds
- Municipal bonds
- Government bonds
- Agency bonds
- Investment-grade bonds
- High-yield bonds
- Junk bonds
- Domestic bonds
- International Bonds
Cash and Cash Equivalents
Cash is exactly what it sounds like: The portion of a portfolio that is held in cash. Cash equivalents, meanwhile, is a term used to refer to certain short-term investments that carry minimal risk and are highly liquid; they’re more or less equivalent to cash. U.S. Treasury bills and money market funds are among the most common types of cash equivalents you might encounter.
Cash and cash equivalents often earn interest. However, the asset class typically plays a much more defensive role. Because cash and cash equivalents do not fluctuate much in value, they can help reduce a portfolio’s volatility while providing liquidity and stability.
Real estate is just that, property. While some investors may buy individual properties themselves, it’s more common to invest in this asset class through something known as a real estate investment trust (REIT). A REIT is a type of company that invests in real estate by either owning, operating, or financing it in order to generate an income or capital appreciation. REITs can be publicly traded or privately held. Shares of publicly traded REITs can be bought and sold on exchanges just like stocks.
By law, a REIT must return at least 90 percent of the company’s taxable income to shareholders each year in the form of dividends. For this reason, some investors choose to invest in REITs in order to generate income for their portfolios.
This asset class is often further subdivided into three sub-asset classes:
- Equity REITs
- Mortgage REITs
- Hybrid REITs
Likewise, it is possible to find REITs that specialize in investing in specific types of real estate, such as single-family homes, multi-family homes, apartment complexes, hotels and motels, office buildings, retail centers, warehouses, data centers, and even healthcare facilities.
Commodities are raw materials, which are either consumed directly or used to make more complex products.
The prices of many commodities often rise during periods of high inflation. With this in mind, investors may choose to allocate a portion of their portfolio to commodities in order to act as an inflation hedge. That being said, commodity prices can be extremely volatile and may not be well-suited for investors with low risk tolerance.
Commodities can be further subdivided into:
- Agricultural commodities (grain, livestock, lumber, etc.)
- Energy (oil, gasoline, coal, etc.)
- Precious metals (gold, silver, platinum, etc.)
- Industrial metals (copper, aluminum, nickel, etc.)
Other Asset Classes
While the asset classes discussed above are the most common that an investor may encounter, other asset classes do exist. These are often lumped together under the umbrella of alternative investments.
Alternative investments can include:
- Private equity
- Private debt
- Art and collectibles
- Hedge funds
Each of these alternative asset classes carries its own unique characteristics; you should consider the risks and potential rewards fully before adding any of them to your portfolio. As just one example, investing in a startup (which is a type of private equity) may offer the potential for very large returns, but it also comes with much greater risk than investing in an established company. In many cases, alternative investments may be highly illiquid, meaning that you may not be able to sell them quickly if you need access to cash. This can be a large risk depending on your situation.
Choose multiple asset classes for a diversified portfolio
A diversified portfolio will typically have investments allocated to nearly all major asset classes. While many investors know that they can and should diversify within an asset class (for example, by purchasing many different stocks instead of just one), it can be easy to overlook the benefits of diversifying across asset classes.
Assets that typically rise and fall in tandem are considered “correlated” and those which move in opposite directions are “negatively correlated”. By including multiple negatively correlated (or uncorrelated) asset classes in your portfolio, it’s possible to provide less volatility in your investment portfolio while not necessarily decreasing return expectations By diversifying across asset classes, you’re also positioned to take advantage of growth that may come from one asset class while others under-perform. A good example of this happened in 2022 when stocks and bonds both lost value at the same time (typically they move opposite of each other). That year, commodities performed exceptionally well.
Different asset classes are better suited to play different roles in your portfolio, such as growth, income generation, or inflation protection. Including multiple asset classes in your portfolio allows you to work toward multiple goals at the same time while enjoying these different benefits.
Building Your Ideal Portfolio
The question becomes: Which asset classes should you include in your portfolio, and how much of your portfolio should you allocate to each?
Unfortunately, there is no single answer that will make sense for all investors or in all situations. Your ideal portfolio breakdown will depend on factors which are unique to you—the most important being:
- Your investment timeline
- Your risk tolerance
- The specific goals that you are working toward
This is where a financial advisor can be a huge asset (pun intended). He or she can build a diversified portfolio that strategically allocates your funds across asset classes. A good financial advisor should also be able to show you how your investment portfolio works with other assets as part of a broader financial plan that’s designed to help you reach your goals.
This article is for informational and educational purposes only and should not be interpreted as financial or investment advice. All investments carry some level of risk including the potential loss of all money invested.
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