You’ve probably heard the words equities, fixed income, hedge funds, private equity, or alternative assets. You may even know that each one is a separate category of assets. But what do these words really mean? And when building diversified portfolios, why do we categorize them differently as asset classes?
Let’s look at these types of asset classes and how they can work together to help you build a portfolio that works best for you.
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What are asset classes?
An asset class is, essentially, a group of securities that have similar risk and return characteristics. When we talk about traditional assets, we’re referring to equities (stocks), fixed income (bonds), and cash. Hedge funds, private equity, real estate, and more recently, cryptocurrencies fall under non-traditional assets or alternative assets.
For example, the rental property you own is an alternative asset — specifically a real estate asset. As a Canadian citizen, the American dollars you bought are a cash asset. Finally, those Apple stocks you want to buy are equity assets.
What is asset allocation?
You’ve likely heard of the importance of diversification when it comes to investing. The idea is, to use a common turn of phrase, not put all your eggs in one basket.
Asset allocation is the conscious distribution of your invested capital among various types of assets. Previously, a 60/40 portfolio was the norm for investors. With this strategy, 60% of an investor’s portfolio went to equity and 40% to fixed income and cash. Now, financial advisors and wealth managers have moved on from this formula, favouring a broader allocation to diversify, minimize volatility, and enhance returns. To do this, alternative assets have become increasingly popular. (More on these below) In other words, investors are putting their eggs into many different baskets.
How many asset classes are there?
Depending on who you talk to, there are a few ways of dividing up the types of asset classes. Specifically, there are several sub-classes of assets out there.
Traditional Asset Class Categories
For most, there are three core traditional asset class categories. Let’s take a closer look below.
Fixed income or bonds
You can think of this asset class in the same way as a loan. When an investor purchases a bond they essentially provide a loan to a borrower for an agreed-upon period of time. They’ll pay back this loan with interest. The interest received is the return in this asset class.
Typically, the expected return on bonds exceeds what they would’ve earned had you held your wealth as cash. An investor can lend to governments at the federal, provincial, or municipal level, too — called government bonds. Alternatively, an investor can lend to corporations by purchasing a corporate bond.
Bonds are referred to as fixed income for the reason that the return an investor will receive is known (or fixed) at investment. The terms of the contract are specified and clearly state the interest that will be paid to the investors, and how often/when the principal will be paid back.
Equities or stocks
This type of asset class gives the investor ownership in the company whose stock they’ve purchased.
For example, when an investor buys shares of Apple Inc. they become an owner of Apple. For equity investors of a company, the return on investment is closely tied to the financial health of the company — as well as the stock price of the company. When the company does well, the investor may receive a dividend payment, plus the bonus of holding an appreciating stock.
An equity investor’s return can therefore take two forms: capital appreciation and/or dividends.
Capital appreciation is the gain achieved through the increase of the stock price, while dividends are paid out to owners of the company from the company’s excess cash. Equity investing carries a higher return potential, as well as higher risk since the investor participates in both the upside and the downside of future returns.
Cash or cash equivalents
Cash is the simplest of all asset classes. It also comes with the advantage of being liquid. Generally, it’s very safe but also delivers the lowest, if any, return. Ultimately, cash is exposed to inflation risk. If you have foreign currency you’re also exposed to exchange rate risk.
What are alternative investments?
Alternative investments is an umbrella term for investments that don’t fit in one of the traditional asset class categories. In this sense, it’s a fourth asset class.
These alternative investments include:
- Private equity
- Venture capital
- Private debt
- Real assets
- Real estate
- Hedge funds
As we discussed in our article about alternative investments, their future has never looked better. Investors are always looking for ways to diversify their portfolios, achieve higher returns, and hedge against volatility, and alternatives provide a whole bevy of options for all types of investors. Morgan Stanley Research has even found that high net worth investors had approximately $16 trillion invested in alternatives in 2020. They expect that allocation to spike to $24 trillion by 2024.
How much should I allocate to alternative investments?
As mentioned, the 60/40 portfolio is outdated. Asset allocation doesn’t adhere to a cookie-cutter formula anymore, with wealth managers and investors favouring a tailored strategy based on individual circumstances.
That said, generally speaking, high net worth individuals can allocate approximately 15-20% of their portfolio to alternatives.
Is there a perfect mix of asset classes?
Understanding these asset classes, their characteristics, and what role they could play in your portfolio is the first step to efficiently managing your wealth.
In summary, the asset mix (or combination of asset classes) held in your portfolio will affect the return and risk of the portfolio. Above all, remember that there is no perfect one-size-fits-all portfolio for everyone. Asset allocations can be based on age, profession, preference towards risk, and the size of your portfolio.
Working with an experienced wealth manager can make this process easier. Ultimately, constructing a well-diversified portfolio by combining various asset classes helps lower portfolio volatility, and puts your portfolio on a course to achieving your financial goals.
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