A Beginner’s Guide to Asset Classes

A Beginner’s Guide to Asset Classes

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Asset Classes = Categorisation

Asset classes are structured groups with securities that behave similarly and boast comparable levels of risk. It is important to appreciate that you will see variances in risk and behaviour between different asset classes. 

Understanding different asset classes can help with asset allocation to diversify one’s portfolio and help mitigate risk (diversification), referred to as ‘non-systematic risk’ (or risk that can be diversified away). This is unlike systematic risk (broad market risk), which cannot be diversified away.  

Common arrangements often used to identify and segregate asset classes are equities, bonds and cash and cash equivalents. These are considered the three main asset classes.

Equities 

Equities represent units of ownership in a publicly traded company on a stock exchange (think the New York Stock Exchange [NYSE] or the London Stock Exchange [LSE]). Unlike exchange-traded stocks, securities traded off-exchange are private securities and can be illiquid and not be subject to regulation. 

The two main ways equity investors generate a return in the stock market are through capital appreciation (the stock’s value increases) and dividend payments (distribution of a company’s earnings to stockholders). Primarily, investors buy stocks via a fund (pooled investment vehicles [think Exchange-Traded Funds, for instance]) or individual stocks.

Two common types of equity securities must be understood: common stock and preferred stock. 

Common Stock:

Common stock provides ownership in an invested company and offers voting rights. This means an investment in the stock will rise and fall alongside a company's market value, opening the door to capital gains. For example, if you invested 1,000 USD in stock A at 10 USD per share (100 shares), and its value increased to 30 USD per share, the unrealised return would be 3,000 USD (100 shares * 30 USD [share price]). Regarding voting rights, common stockholders can vote on important matters such as the election of the board of directors. Nevertheless, as an owner of the company, in the event of liquidation, common stockholders are paid last after all creditors and preferred stockholders. Common stockholders are also not guaranteed to receive dividends. The decision of whether to pay dividends is made by the company's board of directors.

Preferred Stock:

Like common stock, preferred stockholders represent ownership in a company with preferred rights. Preferred shares receive regular (often fixed) dividends that function more like a bond (without a fixed maturity date) and are without voting rights; dividends are paid to preferred stockholders before common stockholders. 

Preferred shares can appreciate in value with this movement largely tied to interest rates (exactly as a bond would: an appreciation in the bond’s price occurs when rates decline).

Bonds—Fixed Income

Unlike shares of stock, bonds and notes (bonds are longer-term debt while notes are short-term debt) are debt securities that do not bestow ownership rights and include predetermined payment schedules. Importantly, a bond investor does not have ownership rights; the investor lends money to the borrower in return for periodic interest payments as well as the return of the principal at the maturity date. Given their fixed and predictable returns, they are often recognised as less risky than equities. Furthermore, bondholders are usually one of the first in line to get their money back in a default situation.

Bonds are essentially an IOU between the investor (lender), who receives fixed periodic payments from the issuer (borrower). Usually, issuers are governments and corporations seeking to raise funds. 

Bond investors tend to look at creditworthiness to assess whether the company (or government) are in good shape to help ensure they will receive the principal back (along with the interest payments). Three of the most well-known credit rating agencies are S&P Global Ratings (S&P), Moody's and Fitch Group. All three publish bond ratings to show a borrower's creditworthiness.

Cash or Cash Equivalents

Cash or cash equivalents are highly liquid assets that are accessible and can easily be converted to cash. 

Cash represents the legal tender you use to make purchases at your local grocery store, for example, and any funds in any account available for immediate use. This is where ‘cash equivalents’ differ; cash equivalents fall under the umbrella of short-term investments of 1 year or less that are viewed as low-risk and low-return investment options and can easily be converted to cash, hence cash equivalents.

Common cash equivalents are Certificates of Deposits (CDs), short-term government bills and money market funds.  

Other Asset Classes

Today, there are a number of investment products that can be positioned under the umbrella of an asset class. These include commodities (divided into two categories: hard commodities [gold, for example] and soft commodities [wheat and coffee]), real estate, derivatives, alternative assets like hedge funds, and things such as fine art and collectables.