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?
What’s an asset class?
An asset class is simply 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 that you own would be considered an alternative asset — or more specifically a real estate asset. The American dollars you bought as a Canadian citizen would be considered a cash asset. Those Apple stocks you want to buy would be considered an equity asset.
Traditional Asset Class Categories
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. This loan will be paid back with interest. The interest received is the return in this asset class.
The expected return on bonds generally exceeds what would have been earned had you held your wealth as cash. An investor can lend to governments at the federal, provincial, or municipal level, and these bonds are 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. As an equity investor (owner) 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 a higher risk since the investor participates in both the upside and the downside of future returns.
Cash or cash equivalents
This is the simplest and most liquid of all asset classes. Generally, it’s considered very safe but also delivers the lowest, if any, return. Cash is exposed to inflation risk, and if you have foreign currency you’re also exposed to exchange rate risk.
Alternative investments is an umbrella term for investments that don’t fit in one of the traditional asset class categories.
While often grouped, they can be divided into different sub-categories of investment strategies. Some popular examples of alternative investments would be cryptocurrencies, hedge funds, commodity investments, real estate, or private equity.
Is there a perfect mix?
Understanding these asset classes, their characteristics, and what role they could play in your portfolio is the first step to efficiently managing your wealth.
The asset mix (or combination of asset classes) held in your portfolio will affect the return and risk of the portfolio. 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. 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.