Asset Classes: The Smart Way to Invest

An asset class is a group of investments that behave similarly, have common characteristics, and deal with the same regulations. 

You can purchase assets within the same asset class in the same manner, and you can hold them either for either the short or long-term.

Choosing to hold multiple asset classes is a better way to diversify rather than choosing only one asset class because each asset class behaves differently to economic changes. 

In this article, you will learn about the different types of asset classes.  

Asset Classes Primer

The three major asset classes are:

  • Equities
  • Fixed income
  • Cash

Each asset class behaves differently depending on economic conditions.  Each asset class has a different expected historical return rate and a corresponding risk to match.  With asset classes, this general statement sums it up the best “the bigger the risk, the bigger the reward (or carnage).”

Different asset classes can move in opposite directions, or they may move in the same direction, but not to the same extent.

What is the Difference Between Asset Classes and Asset Allocation?

With asset allocation, you decide how you want to mix the different asset classes together in your portfolio.  First you select the asset classes for your portfolio and then you assign a target percentage for each asset class.

You may decide to hold 33.33% of your portfolio in each of equities, fixed income, cash and real estate.

Or you might decide to hold 90% equities and only 10% in fixed income.

Most Common (Major) Asset Classes

Here is a rundown of the major asset classes. 

1. Equities (Stocks)

Stocks or equities are riskier than other asset classes, but they offer more upside potential than either fixed income (bonds) or cash.  Stocks are high risk, high reward.  

This category can also include exchange-traded funds (ETFs) that hold stocks as underlying assets, which are likely the best method to achieving wealth for those with long-term investing horizons.

Stocks can be very volatile in the short term, but historically they have been the big winners over longer time periods.   Some individual stocks are riskier than others, so you have to be prepared that your investments could go to zero if you haphazardly invest in this asset class. 

If you want to invest in individual stocks as opposed to equity-based ETFs, then look for stable, mature blue-chip stocks or dividend growth stocks

2. Fixed Income (Bonds)

Fixed income includes bonds and Guaranteed Investment Certificates (GICs).  Both bonds and GICs pay you interest at fixed intervals.

However, bonds come in different flavours.

There are bonds from the various government levels — federal, provincial and municipal.  There are also corporate bonds that are issued by public companies.  

Governments may issue bonds for people like you to buy to help raise money for capital-intensive infrastructure projects. Corporate companies like Pizza Pizza may need to issue bonds to raise the money needed to purchase new equipment to bake pizzas quicker. 

Bonds are essentially a loan that you provide to either a level of government (government bond) or a corporation (corporate bond).  When you purchase bonds, you are now taking the role of the lender. 

The government or corporation promises to make periodic interest payments (usually every 6 months).  At the end of the bond term, you will receive your last interest payment (also called a “coupon”) and also get back your full principal amount (the original money you invested).  The end of the bond term is known as the maturity date. 

A bond can be issued with a term of five years, with interest paid every 6 months. 

We refer bonds to as fixed-income because your return is known- you will receive interest payments and your original principal back.

Government bonds are much safer than corporate bonds because the federal government will print money before defaulting on a loan.  

A company that offers a corporate bond could default on paying you back your interest owed.  This serves as a reminder that any investment carries some level of risk.  For companies, you should refer to their credit (bond) ratings to gauge how likely it would be for them to pay you back.

Standard and Poors and Moodys are two companies that publish bond ratings.  Companies that are rated AAA+ or AA will most likely be able to pay you back because they are in a strong financial position. 

Companies with strong bond ratings will offer you lower rates on their bonds.  When you see a company offering a higher interest rate on their bond offering, it means they are likely on shakier financial ground and the risk of default is higher. 

In general, bond investments are low-risk, low-return assets and are great to have in your portfolio in order to reduce risk and stop your portfolio from totally free-falling in a bear market. A lot of the larger bond ETFs hold government bonds. 

With the current historically low-interest rates being offered, bonds are barely keeping pace with inflation.

However, bonds let you stay the course with your investment plan.  That is the name of the game. You need to give your portfolio the proper time to compound your money and drive true wealth.  Bonds earn a cherished place in your portfolio simply because they will help you sleep better at night. 

General personal finance advice is to set the bond allocation of your portfolio to a percentage equal to your age minus 10%.  This rule means if you’re fifty years old you should hold 40% of your portfolio in bonds.

Of course, your own appetite for risk plays a role here too, and not everyone follows this advice.  The closer investors get to retirement, the more they tend to hold stable bonds or fixed-income assets in their portfolios.  The reason being is that a market crash could greatly affect your retirement savings, a phenomenon knowns as sequence of returns risk.

   

3. Cash/Cash Equivalents

This category includes cash, money market funds and high-interest savings accounts.

Cash is the $20 in your purse or wallet, the roll of coins you have on your bedroom shelf, or the money you have in your bank account.

There is very little way of realizing returns with this group of assets because of the current low-interest rates being offered for savings accounts.  In fact, the returns are likely to be flat or slightly negative once you factor in inflation (which usually runs at 2% per year in modern times).   

However, the tradeoff is that you can sleep well at night knowing that you won’t see any drastic reductions in your portfolio values with this asset class.

If you hold your cash in a cash equivalent like a high-interest or Guaranteed Investment Certificate (GIC) you would likely match inflation during normal years. 

Sometimes you hold more cash than usual if you’re waiting to make a large purchase, you want to build an emergency fund or you are saving for a down payment for a house or a wedding.  You normally hold cash for short-term financial goals.

Cash is frowned upon in the Personal Finance Community because you can earn far more money investing and that is true from a numbers standpoint. 

From a psychological standpoint, holding a large cash position could be the one thing that gives you confidence to invest any money in the stock market.  It can also be the sole reason you don’t sell out of your equity investments when the market takes a dive. 

Cash is also wonderful to have to capitalize on any opportunities that the stock market may provide if there is a correction or crash.    

Four Major Asset Classes

4. Real Estate / REITs

Investing in real estate happens in any of the following three ways. 

1. You can buy physical rental properties and become a landlord.  You can earn rental income and the property may increase in price.   The rental income helps you pay off the mortgage.  The key to rental properties is to ensure that you can remain cash flow positive, where your rental income is higher than your expenses for holding the property.  

2. You can rent out a portion of your own home and again become a landlord.  Your tenants will pay a portion (or your entire mortgage) for you.  The difference is that you all live in the same residence, usually separated by a basement door.

3. You can invest in Real Estate Investment Trusts (REITs).    If you have no desire to become a landlord, you can purchase REITs in the stock market.  You can invest in REITs that hold residential (apartments), commercial, industrial or office spaces.  Some REITs offer a mix of residential and commercial properties as well.

A REIT can hold hundreds or thousands of properties and is required by law to pay you distributions from their share of the rental collection from their tenants. 

How wonderful! You don’t need to fix anything, buy a property or go to the bank to finalize a mortgage. 

Overall, real estate can be risky and if you are buying properties outright, it can be very capital intensive.  However, it can also be highly lucrative if done right.

Real estate is not correlated with bonds or stocks and it keeps your portfolio diversified.

Other Asset Classes

Of course there is much more to investing life than just equities, fixed income, cash and real estate. This section begins with an asset class that is incredibly popular.

5. Commodities

This category includes lumber, oil, and metals such as gold and silver.  These categories are volatile and have cyclical price swings, but these asset classes are not directly correlated to other asset classes, such as bonds or equities.    

When there are economic hardships or downturns, investors may flee to assets like gold and silver as a hedge against falling currency values. 

6. Currency Holdings

You can hold investments in Canadian dollars, US dollars, or buy Euros or Japanese Yen if you feel unsure about the stability of your domestic currency.  Or you may do this because you want to have what you perceive to be, a stronger currency.   

7. Digital Currencies

Towards the later part of 2020 and early 2021, cryptocurrencies such as Bitcoin and Ethereum took over the news headlines.  Bitcoin is no stranger to the spotlight, but this is a technology that differs substantially from the world of fiat currency, which is regulated by the government. 

This is an extremely risky asset class to own, so you must be careful and do your own due diligence here or speak to an investment or financial advisor.  You should only consider this type of asset class if you believe it is the future of money and/or you believe that regular fiat currency is going to be devalued.   

The biggest problem here is that no one knows if digital currencies are the future, or if they are a meme.

This asset class provides instant diversification because it is uncorrelated to all other asset classes.

8. Collections

You can have many collections.  You can own collections of paintings, wines, books, vinyl, cars, sports memorabilia, or even antiques. These assets are also highly uncorrelated with stocks and bonds. 

9. Stock Options or Employer Stock Purchases

Sometimes you are fortunate to work at a company that gives you a stock option as part of your compensation package.  That means that you can purchase shares of your employer’s stock for a discount.  Usually when this happens, you may end up with a large investment in your employer’s stock. 

Most people are already 100% reliant on their income from their 9-to-5 jobs, and if you invest in the same company (even at a discount) then a higher proportion of your net worth is tied to one employer. 

Companies that offer stock options are generally bigger companies, but big companies can still fail from time to time.  So try to sell your company stock positions after they get to a certain level. 

Suppose you invested $3,000 in your company’s stock and it reaches a value of $6,000, you may decide to sell $3,000 worth of the stock and purchase an ETF instead.

10. Your Company Pension Plan

A defined benefit pension is a retirement plan that both you and your employer contribute to throughout your career at a company.

After 20 or 25 years, you can retire with a specified annual amount of money based on a formula that takes into consideration how much you have earned and the number of years you have worked.  The higher either of those variables is, the more you will receive from your pension.

Some people are fortunate enough to have defined-benefit pensions of $50,000 a year or more.  With greater retirement income stability, you can afford to invest more into higher-risk asset classes because your defined benefit pension plan acts like a gigantic bond. 

A word of caution if you have a defined benefit pension plan in the private sector.  Anything can happen.  There have been a few instances where companies have gone bankrupt and the employee pensions have disappeared or been drastically reduced.  

Asset Class Sub-Categories

You can further divide each one of the asset classes above into sub-categories.  You can split stocks into domestic, international, large-cap, small-cap, dividend growth, or penny stocks, etc.  The risk can vary depending on which of the above you choose. 

You can purchase blue-chip stocks like Royal Bank and Telus.  Or you can try to get rich quickly (which rarely works) with meme stocks.

With bonds, you can choose much safer federal or provincial bonds, or you can opt for corporate bonds which carry more risk. 

Asset Classes Conclusion

In your portfolio you need to have a mix of different asset classes so that one event doesn’t send your portfolio cratering.  Each asset class behaves differently depending on the macro and micro environment.  Diversifying your portfolio amongst different asset classes reduces the risk and volatility you will face. 

Which asset classes do you like investing in, and which have given you the highest returns?  Let us know in the comment section below.  

Asset Classes FAQs

What are the 4 different asset classes?

The four main asset classes are: equities, fixed income (bonds), cash/cash equivalents and real estate.  

What is the safest asset class to own?

Historically cash, money market funds and guaranteed investment certificates are the safest assets to own and they fall under the “cash/cash equivalent” asset class.  The goal here is protection of the asset value, above all else.  In return for safety you as an investor should be willing to accept a low return.   

What are some other asset classes?

Aside from the major asset classes, other types of asset classes include commodities, currency holdings, digital currencies, collections (private), stock options, and company pension plans. 

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