Understanding Asset Classes

An asset class is a group of securities with the same characteristics, especially with regard to risk. There are three main asset classes – equities, bonds and cash. Some professionals also add real estate and other commodities like art and gold when discussing asset classes. Apart from varying levels of risk, each asset class also has a different potential for delivering returns in various market conditions.

WHY DO YOU NEED TO KNOW ABOUT ASSET CLASSES?

It is essential that you know the characteristics of the asset that you are investing in, so you are able to adjust your expectations accordingly. The financial landscape is always changing, so knowing about the different asset classes and how they are performing currently can help you plan how to invest your money. You have to understand the risk and rewards characteristics of any asset you want to invest in, and ensure that it is in line with your own needs to make an appropriate decision for you.

TYPES OF ASSET CLASSES

Equities

Equities (also called stocks or shares) are issued by companies and some are traded on the stock market. When you invest in an equity, you buy a share in a company, and become a shareholder. You can make money from equities in two ways: growth of your capital when the share price increases, or you can receive income in the form of dividends. Neither of these is guaranteed and there is always the risk that the share price will fall below the level at which you invested. Also, past performance of a stock does not guarantee future performance. Equities generally are more unpredictable in the short term, but they have historically outperformed other investments. 

Bonds

Bonds (also called fixed income or debt) are loan instruments issued by governments and companies to raise money. When you buy a bond, you lend money with the purpose of receiving interest. Bonds usually pay a set rate of interest at regular intervals over a given period, thereby giving you stable returns and steady income, and return your capital after the set period. They are more stable and have lower risk than equities, but typically, also deliver lower return over the longer term. However, they are not all risk-free – if you invest in bonds that are not guaranteed by governments in stable economies or companies with a good track record and health, you face the risk of non-payment of both your interest and capital. The value of bonds are sensitive to changes in both interest rates and inflation.

Money Market Instruments

Money Market instruments are relatively safe short-term investments aimed at preserving capital and providing steady income based on general interest rate level. Such investments can be made in treasury bills (government securities), bankers’ acceptances and commercial papers. Money Market Instruments typically have lower risk and return than equities and bonds, and are usually geared towards investors that are risk averse. However, as they usually offer lower rates of return, they are not advisable for investors that would like to grow their capital in the long term. The best thing about money market instruments is that they are very liquid which means that investors can withdraw their money whenever they want.

Real Estate

Real estate can be land or property. You can invest in real estate to live in or for investment purposes -- apartments, rental houses, office buildings and malls all generate income through rents. Values tend to rise and fall more slowly than stock and bond prices. Real estate helps to protect against inflation as property values and rental income typically rise faster than inflation, but is subject to a number of risks including liquidity and marketability.

WHICH ASSET CLASS SHOULD YOU INVEST IN?

Asking the question, "What asset class is the best investment?" is like asking if vanilla is a better flavor than chocolate. There is no correct answer because the best investment actually depends on your personality, preferences, and needs. The specifics of the individual investment also have a lot to do with your investment profile - so what you always need to keep in mind is your investment goals, investment horizon and risk appetite.

Nevertheless, most financial experts agree that the best investment strategy is to spread your investment across broad asset classes to reduce your risk. This is because a fall in the return of one asset class due to market conditions may not affect you as much. You can do this by investing in a mutual fund that invests in the different asset classes, but be sure to choose a fund with a mix (in terms of the ratio invested in each asset class) that is right for you.