The Basics of Asset Classes

If you have ever come across the phrase ‘investment vehicle’ and wondered what it means, here is a simple explanation. An investment vehicle is any method that is used by individuals or companies to invest their money and gain returns from it. An asset class refers simply to a group of similar investment vehicles. Usually, it is advised that investors keep different asset classes in their portfolio of investment, which is called diversification, and the particular asset allocation depends on many factors such as an investor’s knowledge of financial markets, risk appetite, financial goals, and current financial resources at hand. 

Although the exact number of types of assets are argued and new innovative asset classes can be invented, in general, five asset classes are identified by most financial experts.

Stocks or Equities

Stocks or equities are investment products enabling investors to own a share in publicly-traded companies. These products can be traded in stock exchange markets such as New York Stock Exchange (NYSE) and NASDAQ and bring owners a dynamic profit based on the investee company’s financial performance. Equities are usually further categorized based on market capitalization into small-cap, mid-cap, and large-cap stocks which will be elaborated on in one of the coming articles.

Bonds or Other Fixed-Income Investments

Investment vehicles under this asset class are considered lending investments. In other words, investors buying bonds of a company basically lend their money in return for a fixed income in form of an interest rate. Such instruments generally imply less risk for investors than equities since they guarantee a fixed income coming from a fixed interest rate. One increasingly widespread type of bond investment is green bonds which are when the entity issuing the bond (borrowing the money) uses the received funds for sustainable activities, i.e. for environmentally and socially beneficial objectives.

Cash or Cash Equivalents

This asset class is one of the most important indicators of a company’s financial health since it tells a potential investor whether the company is able to pay its bills in a short time. It includes investment products ranging from Treasury Bills or T-bills issued by the United States Department of Treasury, commercial papers, and marketable securities to short-term government bonds and marketable securities. 

The main advantage of cash and cash equivalents resides in their ability to be easily accessed or converted into cash. Hence they are low risk and usually low return. Think of a savings account in a bank that is basically money-bringing money, or any asset that is easily convertible to cash. Prudent companies usually maintain a balanced amount of cash assets or cash to meet their immediate expenses and invest the rest of the cash in higher-return assets such as stocks or equities.

Tangible Assets Such as Real Estate

Real estate is one of the physical assets whose main advantage is providing protection against economic uncertainties such as inflation. Tangible assets are sometimes referred to as ‘real’ due to their existence outside financial statements and stock exchange markets and their natural value. This asset class is also named cash equivalents or ‘alternative’ investments and most commonly entails investments in the form of real estate, gold bullion, a piece of art, or jewelry.

There is a reason and evidence as to why tangibles act as an inflation hedge. It becomes self-explanatory if you only look at the purchasing power trend of the dollar (which declined 95 percent in the last century) and the value of a unit of gold (which climbed up around 2500 percent in the same period). For this reason and others, it is advisable to have a tangible asset in your investment portfolio to have diversification and protection against the ups and downs of financial markets.

Derivatives Such as Futures

Derivatives are an interesting class of asset whose value is dependent on or derived from an original asset or assets such as stock options being derivatives of stocks. When you invest in a derivate, you are basically having a contract with another party, and the value of the contract is underlined by and changing with the basis of securities – stocks, bonds, currencies, interest rates, and others.

There are expanding types of derivatives in the market based on a lot of different transactions, even the number of rainy days in a region. A common type of derivate transaction is futures – which is a contract between two sides for the purchase of an asset, say a certain amount of oil, in the future at an agreed price. Why would someone use this as an investment instrument? Simply to protect themselves against a perceived rise (or fall) in the price of an asset of interest. As an example, if you want to buy some amount of X which is currently priced at $10, but you expect that this price will rise to $20 in a near future, you might want to agree with the seller of X to buy it at $10 after one month – when the agreed contract expires. If the price does rise to more than $10 at the date of exchange, you win. Of course, it may as well fall below $10 and you could lose your money, but in any case, this is an investment vehicle suitable to your risk appetite and expectations.

When the buyer and seller trade this kind of asset over-the-counter (OTC) (simply meaning, privately and in an unregulated market), it is called ‘forwards’. When there is no obligation of buyers and sellers to actually buy or deliver the underlying asset (e.g. oil in our example), then this asset is called ‘options’. 

Today, financial markets are abundant with differing types of instruments to trade and gain profits and speculate on dynamic phenomena such as interest rates, market indexes, and even weirdly unusual concepts. To know where to invest your money, it is crucial to have a basic knowledge of different asset classes and allocate finances in a wise way.

Photo: TimeShops/Shutterstock

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