Before jumping headfirst into the world of investing, it may be smart to educate yourself on where your money will be invested. This is where asset classes come in. Simply put, asset classes are groups of similar investments, like commodities or stocks. And a well-diversified portfolio may have a variety of asset classes that offers you different levels of risk and return. But what does that mean? Here’s a breakdown of the variety of asset classes you can invest in.
Investing in Asset Classes
It’s smart to have a variety of asset classes in your investment portfolio. This helps diversify your investments and the level of risk and return that comes with each one. However, there’s usually no correlation between asset classes and investments. In general, equities or stocks, fixed-income securities, cash or cash equivalents and real estate or commodities make up the main asset classes. Futures, other financial derivatives and even cryptocurrency may also be added as asset classes, though they may not be as popular. We dive into the four main asset classes below.
Equities or Stocks
When you purchase equities or stocks, you are essentially buying a portion of a company. In other words, you own a share of the company and would be considered a shareholder.
Investors make money on stocks in one of two ways. You may earn dividends, or quarterly payments of the company’s earnings made to shareholders in the form of cash or stock. But you can also earn money on equities or stocks by selling your shares at a higher price than what you paid for them. Remember, stock market prices fluctuate for a variety of reasons: supply and demand, economic events, natural disasters and even interest rates.
If you chose to invest in this asset class, you may want to use an index as a benchmark for your investments. The three main indices are the S&P 500, the Dow Jones Industrial Average and Nasdaq. You can purchase an index fund or an exchange-traded fund (ETF) that generally follows these indices. In short, you’ll want to “beat” the index.
The second major asset class is comprised of bonds and other fixed-income securities. Fixed-income securities are those that provide fixed, regular interest payments, plus the return of the principal when the security matures. These interest payments, called coupon payments, are generally paid out semi-annually.
Bonds are the most common type of fixed-income securities. These debt instruments are used by the federal government, a city or company to raise money to pay for a specific project or operations. Essentially, it’s a loan an investor makes to a company.
It’s important to know the basics before investing in bonds. The face value of a bond is how much the bondholder will receive when the bond reaches its maturity date. Its current yield indicates the interest rate the fixed-income security is delivering, which tells an investor how profitable a bond might be.
Cash or Cash Equivalents
While the name might denote otherwise, this asset class is comprised of more than just cash. Examples include bank accounts, Treasury bills, commercial paper and short-term government bonds.
A Treasury bill, also called a T-bill, is a fixed-income security issued by the U.S. Treasury. It’s a short-term debt obligation with a maturity of one year or less. (This is what makes it fall under the cash or cash equivalent asset class.)
Commercial paper is a fixed-income security used by large corporations or banks to meet a short-term financial need. This means it’s a type of short-term security, and it often reaches maturity in 270 days or less.
A short-term government bond is similar to the aforementioned bond (and a whole different asset class altogether), but it differs in that the timeframe to maturity is shorter than a traditional bond.
The hallmark of this asset class is that its components are liquid. This means it can easily and quickly be converted into cash.
Real Estate or Commodities
This type of asset class is comprised of owning physical objects – anything from real estate to precious metals.
Investing in real estate can include anything from owning rental properties to purchasing and flipping a house, to owning a vacation home. Even using a rental vacation platform like VRBO or Airbnb counts. If you want to invest in real estate but aren’t so hot on the amount of money you may need to get started, try investing in a real estate investment trust (REIT), or a real estate ETF or mutual fund.
An example of investing in a commodity is investing in precious metals. While you can buy physical quantities of gold and silver, you can also invest in precious metals via the stock market. Other commodities may include valuable artwork or collectibles.
The Bottom Line
While investing money may be intimidating to beginners, it can also help you grow your wealth. It’s important to understand the different asset classes before investing your money. Investing in different asset classes helps you diversify your portfolio and it could help you reach your financial goals faster.
Tips for Investors
- Asset classes are groups of similar investments. The main asset classes are equities and stock, fixed-income securities, cash or cash equivalents and real estate and commodities.
- A well-diversified portfolio is more likely to be a profitable one. This is why it’s important to familiarize yourself with the various asset classes and build your portfolio accordingly.
- If you’re not sure how to diversify your portfolio, a financial advisor may be able to help. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
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