An asset class is a group of securities that share a similar return and risk characteristics. When it comes to investing there are three primary asset classes: cash, fixed income, and equity. And while there are more non-traditional asset classes available today, most investment portfolios consist of the three traditional asset class (cash, fixed income, and equity). If you want to invest, you first need to understand what each of these asset classes is and their respective risk and return profile.
Cash asset class offers the lowest risk profile of the three asset classes. While its risk profile is low, it’s expected return is the lowest among the other two asset classes. Cash offers security in the sense of seeing your money each day but can be detrimental for long-term growth as inflation erodes your purchasing power each year. Inflation is the invisible thief we never see but is constantly trying to steal your money. That being said, cash can play an important role within an investment portfolio.
Fixed income asset class is riskier than cash but is more likely to generate a higher return than cash. Bonds are the most common fixed income security you will hear of. Fixed income assets are subdivided based on their credit quality, term maturity, or by geography to name a few. Bonds are usually held in a portfolio to offset some of the risks associated with holdings equity or reduce the portfolio’s overall risk profile. In a simplified way (very simplified), the more fix income you have in your portfolio the lower the portfolio’s overall risk profile. An investment portfolio that consists entirely of fix income securities would likely not make sense for a young person. That’s based on the assumption that a young investor likely requires their investment to grow over time. Debt securities (another name for fix income asset class) do not offer as much growth potential as the equity asset class.
Equity asset class offer the highest possible return of the three asset classes but has the highest risk profile. Similar to fix income, equity asset classes can be further subdivided into smaller groups based on investment style, geography, or market capitalization. Equities is an important piece to have in your portfolio because it’s where you can generate the greatest return. Equities provide an opportunity to grow an investment over the long term but also offer the greatest volatility among the three asset classes.
Putting it all together
Creating an investment portfolio is like making a pie (I haven’t made one but I’ve seen others do it). A good pie is the result of all the ingredients being mixed in the optimal proportion to each other. Asset classes are the ingredients for creating an investment portfolio. The mixing of asset classes is known as asset allocation when investing. Basically, you’re trying to figure out how much of each asset class (cash, fixed income, and equity) you should have in your investment portfolio to generate the return you require to meet your goal while ensuring it also suits your risk profile.
It’s a delicate balancing act because you might require a 10% rate of return but are not comfortable with taking the type of risk required to get a 10% rate of return. Your risk profile plays a big part in determining how much stock, bonds, or cash you will have in your investment portfolio. In knowing how each asset class behaves and the risk profile of each, you’re able to construct an investment portfolio that will suit your risk profile while allowing you to meet your investment goals.