Asset Classes Explained

What is an Asset Class?

An asset class is a grouping of investments that demonstrate similar characteristics, behave similarly in the market, and are subject to the same laws and regulations. There is often very little correlation and sometimes even a negative correlation between different asset classes. For example, in a normal market cycle equities and bonds are negatively correlated, i.e. when share prices go up bond yields go down. Financial advisors use different asset classes as a way to help investors diversify their portfolios.

Cash and Cash Equivalents

Cash is the asset class that you probably know the best because we use it to buy goods and services and pay off debts. Cash equivalents are investments that can easily be converted into cash. For example, premium bonds, money market funds and U.S. Treasury bills. Cash and cash equivalents are a low-risk asset class, it does not pose any capital risk. The main disadvantage of cash is the danger posed by inflation risk, which happens when your savings are not accruing enough interest to beat the rising cost of living, as is currently the case. There is also the rarer possibility that banks might default, however, if the institution is backed by the Financial Services Compensation Scheme (FSCS) then your money is protected up to £85,000 per person, per banking licence.

Equities 

When people talk about equities, they are usually speaking about owning shares in a company. Companies sell slices of ownership in exchange for cash to the public in order to expand and meet their goals as a firm. These shares are traded on the stock exchange and an investor can profit from the success of a company. The value of equities can rise or fall based on the company's performance, investor demand, and other factors. Therefore, there is a high market risk when investing in equities and investments can fall drastically in market downturns. Ideally, the shares value would increase in value over time and create returns for investors. The best way to combat this risk is to diversify your equity investments by investing in many different companies in different sectors, as well as ensuring that you have a wide spread of regional exposures in your portfolio. As well as diversifying equity exposure, investors often hold different asset classed in their portfolios as a way of diversifying risk. 

Fixed-Income Securities

Fixed-income securities, or bonds, are debt instruments that are split up into units and sold to investors. They pay a fixed amount of interest to the investors. Usually, the interest is paid semi-annually and the principal investment is returned to the investor at maturity. Bonds are the most common form of fixed-income. They are used to raise funds for governments and corporations and can be traded on exchanges.
Bonds securities are less risky than equities, but they are not as safe as simple cash-based products. Bonds carry interest rate risk, which means that when rates rise then there is a lower demand for fixed-income products and bond prices fall. With corporate bonds there is also a default risk, the company who you are lending could essentially fail to repay the borrowed money, with interest, over time. 

Alternatives

Alternative investments is an asset class for anything that's not cash, equities, or fixed income. For example, this includes real estate, commodities and precious metals. Most alternative assets are reasonably illiquid compared to equities, bonds and cash. Alternatives often have low correlations to traditional investments such as equities and bonds. Therefore, they can help to diversify an investment portfolio and reduce the portfolios risk. Some alternatives are also safe haven assets, meaning that investors turn to them in times of market volatility or high inflation environments, a good example of this is gold.

Conclusion 

It is worth remembering that not all investments behave the same. Whilst we have named a number of different asset classes that could provide positive growth, there are many other ways to invest and it’s important to remember that not all investments behave the same in different economic cycles. Investments can go down as well as up and even lower risk asset classes still hold some hazards, especially when you have not diversified your portfolio. There are benefits and drawbacks to each asset class and it’s important to have a mix of different investments within a portfolio to benefit from the characteristics of each, whilst reducing the amount of risk you are taking.

Please note: This article is intended as information only and does not constitute individual advice.  If advice is required, please ensure this is sought prior to taking any action or inaction. The value of investments can go down as well as up, you may not get back what you originally invested.