A financial asset is a non-physical agreement that gets its value from a contractual claim. This means it shows your ownership of something or your right to payments from it in the future. Financial assets are almost always electronic, and are grouped together into asset classes. In this guide, we explore what an asset class is, types of asset classes and why they’re useful.
What is an asset class?
An asset class is a group of financial assets that are very similar. They are usually subject to the same laws and regulations, and behave in a similar way.
Each asset class reflects different risk and return characteristics and performs differently in any given market environment – so if you want to invest in assets you probably don’t want to put all your investments into one asset class. A financial advisor will help you diversify your portfolio by combining assets from different classes that might have different cash flow streams and varying degrees of risk.
By investing in several different asset classes, you can maintain the right level of risk and return across your investment portfolio.
Diversification is important to reduce risk and increase your probability of making a good positive return. There is a good summary of what diversification is here.
Types of asset classes
The most common asset classes are:
Cash and cash equivalents
Cash and cash equivalents represent actual cash on hand and securities that behave in a similar way to cash. They are considered very low risk since there is little to no chance of losing your money. However, that peace of mind also means the returns are lower than other asset classes.
Assets in this class include savings accounts, US treasury bills, guaranteed investment certificates (GICs) and money market funds.
Fixed income assets
These are simply any investments that pay a fixed income. In effect, you lend your money to an entity and, in return, they pay you a fixed regular amount until the maturity date – when the loan is paid back to you.
The commonest types are probably government and corporate bonds. The government or company will pay you interest for the life of the loan. The rate depends on things like inflation and perceived risk.
Now, the risk that certain governments will default on their bonds is very low – so they pay out less. However, some companies in riskier, maybe volatile sectors need to pay investors a little more to convince them to part with their money. But the risk is higher.
Equities
This typically means shares in a company. Companies issue shares – or sell slices of ownership – in exchange for the cash they need to invest or grow. Shares are available to the general public, and allows you to profit from the success of a company.
There are two ways you can make money from shares: dividends and selling at a profit. Remember though, markets are volatile and share prices can fluctuate – some companies (even the big ones!) can go bust.
Commodities
Commodities are basic goods that can be transformed into other, more valuable goods and services. So, things like metals, energy resources or agricultural goods.
These are seen as so crucial to the economy, so in some cases they are seen as a good hedge against inflation. The return you get is based on supply and demand dynamics rather than just profitability.
You can invest indirectly in commodities by buying shares in companies that produce them. However, there is also a huge market for investing directly, whether that is actually buying the physical commodity with the view of eventually selling it for a profit or, more likely investing in futures. Futures are financial contracts where you promise to buy an asset at a predetermined price on a specific future date.
Alternative asset classes
Alternative asset classes include tangible property like real estate, and valuable inventory, such as artwork, stamps, and other tradable collectibles (whisky and wine). This can also include hedge funds, venture capital, crowdsourcing or cryptocurrencies.
Traditional asset classes typically form the backbone of most robust investment portfolios. They offer liquidity and are generally well-understood. However, their returns can be less exciting.
The alternative asset classes, on the other hand, are far less liquid and can require longer investment horizons. While these typically attract higher fees and offer less transparency, they can offer potentially higher returns.
Conclusion – why are asset classes useful?
Financial advisors focus on asset classes as a way to help you diversify your portfolios and get the best returns with the lowest risk. Each asset class reflects a different pattern of risk and return, with different investment characteristics. Each performs differently in any given market environment. By sharing investments across a range of different classes when you invest in assets, you can make sure you have the right amount of diversity in your investment selections.
Speaking to one of our market-leading financial advisors can help you determine which asset class to invest in based on your specific goals. Get in touch today to start preparing for your future.
