Investing > Asset Classes Explained

Asset Classes Explained

All asset classes behave differently—and understanding those differences is key to developing a winning investing strategy.

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Updated March 03, 2022

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Do you know exactly what to invest in? 🏛️

You might have a general idea—the ratio of risk and reward that equities present might appeal to you, or you might be more risk-averse, and as such, leaning toward fixed-income securities. However, if you don’t have a solid grasp of the fundamental differences and behaviors of all possible asset classes, you’ll never be able to maximize your returns.

To be fair, there’s a lot to cover here. The topic of asset classes encompasses everything you could possibly ever invest in. You don’t have to know the nitty-gritty details and minutiae of everything—but you have to know the basics. Should the stock market experience a recession, you need to be able to branch out into other types of investments.

We know that this isn’t easy—above all, the terminology of the finance world appears quite inaccessible at first glance. Stocks, bonds, exchange-traded funds, commodities, derivatives… it’s enough to make your head spin.

But if all of it is laid out in plain language, along with simple explanations as to what’s what, then mapping relevant information to these intimidating words becomes a piece of cake. And that’s exactly what our goal will be here today.

Nothing can be done successfully with surface-level knowledge. If you’re to be successful, it will require a lot of study, practice, and effort. But to even get the chance to do that, you have to make the first step and understand the basics.

So, let’s not waste any more time. We’ll go over all of the available asset classes, explain what they are, how they behave and present all the most relevant information regarding them. Once you’ve absorbed that knowledge, you’ll have conquered an important stepping stone—one which will allow you to go further in the direction that suits you the best.

What you’ll learn
  • What are Asset Classes?
  • Stocks Explained
  • ETFs and Mutual Funds
  • Fixed Income 101
  • Cash as an Asset
  • Forex Explained
  • Is Cryptocurrency an Asset?
  • Real Estate and Other Tangible Assets
  • Derivatives
  • Commodities
  • Invest in Different Asset Classes
  • Get Started with a Stock Broker

What Are Asset Classes? 🧠

Asset classes are groups of investments that are similar to one another—they behave the same way, they’re traded on the same marketplaces, and they have to meet the same criteria and regulations.

But the differences aren’t only formal—financial instruments to the same asset class generally exhibit the same levels of risk and the same potential for returns. They also tend to behave the same way in specific market conditions—for example, the announcement of important economic metrics often causes the average price of an entire asset class to surge or falter.

How Many Asset Classes Are There? 🤔

In general, people tend to group investments into one of three large categories—equities, fixed-income securities, and cash equivalents such as money market instruments.

However, that is a bit of an outdated view, and it simplifies the reality of how diverse the market actually is. If you want to get a more actionable overview of asset classes, there are 8 separate ones that you should be aware of—and that includes knowing the basics of what they are, how they operate, and their typical risk profile and potential returns.

These categories are:

  1. ☑️ Stocks and equities, including funds
  2. ☑️ Fixed-income securities
  3. ☑️ Cash and cash equivalents
  4. ☑️ Foreign currencies / foreign exchange
  5. ☑️ Cryptocurrencies
  6. ☑️ Real estate and tangible assets
  7. ☑️ Derivatives
  8. ☑️ Commodities

Obviously, there’s a fair bit to cover here. Don’t be discouraged if you can’t absorb and neatly categorize all of this information at once—this guide won’t go anywhere, and we recommend taking another look whenever you forget something. Also, keep in mind that a lot of the top stock brokerages offer a lot of quality educational material—which is a great way to supplement your learning path.

Types of Investments in Brokerage
Most brokers allow users to invest in all asset types either directly, or through derivatives.

Stocks Explained ⚖️

Stocks or equities represent a small unit of ownership in a company. They are the most popular, accessible, and prominent investment vehicle in the world today. In fact, they’re also the best-performing asset class, if we look at historical data. Since the 1920s, the typical stock market return has been around 10%.

However, those returns come at a price—and that price is risk. Equities are considered the riskiest asset class, and there are no guarantees that you’ll profit from buying them—that’s entirely up to whether or not the business in question thrives in the marketplace. Stocks are traded on exchanges such as the NYSE and NASDAQ.

One of the greatest advantages that stocks have is that they are highly liquid—the large trading volume that they exhibit means that it’s usually easy to sell or buy stocks whenever you want. Stocks can also serve as a source of passive income—some stocks pay dividends, which are small sums of money that a business pays to shareholders, usually on a regular basis. In fact, there’s an entire investment strategy based around dividends.

Stocks can be divided by market cap—the overall value of the company in question. Penny stocks, small-cap, medium-cap, and large-cap or blue-chip stocks all exhibit different behaviors, risk profiles, and potential returns.

When looking at how stocks perform in the marketplace, we can draw a distinct line between growth stocks and value stocks. Stocks are also divided by sector or industry, and by geography—domestic stocks, foreign stocks, and emerging-market stocks being the usual way of looking at things.

Funds: ETFs and Mutual Funds ⚔️

Funds are another category of equities. Unlike a stock, which is a small slice of a company, so to speak, a fund is a bundle that contains many different investments. 

That’s a bit of oversimplification—most funds contain both stocks and bonds, however, they can also include other asset classes—but they’re purchased in the same way stocks are, and tend to act more like stocks than anything else. Funds are divided into two main categories—exchange-traded funds, also commonly called ETFs, and mutual funds

Funds are incredibly diverse—some focus on specific regions, markets, and industries, while others aim to achieve passive income, or a diversified asset allocation.

Exchange-Traded Funds 💲

The main difference is that ETFs tend to track a specific industry, commodity, or underlying asset, with the aim of providing accessible, passive investing and diversification that doesn’t require a hands-on approach. In essence, an ETF tries to replicate the average performance of a section of the market or a certain index in the case of index funds.

Types of ETFs
Just like mutual funds, ETFs can focus on many aspects of the market, making them suitable for focused and broad portfolios alike.

ETFs have a variety of advantages when compared to asset classes—seeing as how they’re a bundle of different securities, it’s unlikely that they’ll all see losses—in general, ETFs are considered to be among the safer investments. On top of that, ETFs can also provide dividends, and offer a simple, straightforward way to branch out into new industries and foreign markets. In fact, there are some brokers that specialize in ETFs.

Mutual Funds 🗂

On the other hand, mutual funds are actively managed by professionals who pick and choose the investments that go into the fund, and they try to beat the market. When we compare stocks and mutual funds, it’s clear that investing in mutual funds is a great way to diversify without having to do a ton of research on your own. 

You’ll have the added benefit of professional management—but there is a tradeoff, as mutual funds are typically more expensive than ETFs. On average, you can expect to pay an expense ratio of between 1% and 3% if you decide to go with mutual funds.

Another factor that might interest you is sustainability. Environmental concerns are an important topic nowadays—and the world of finance isn’t an exception. Investment methods such as ESG investing and impact investing are becoming increasingly popular—and these green funds are showing promising returns, even surpassing the S&P 500 at times. 

Keep in mind that they aren’t foolproof—greenwashing is still a concern, but if you’re interested in sustainable investing, funds are the best way to make your investments align with your moral compass.

Well, that’s all well and good—but let it not be said that we’re keeping the downsides from you. Apart from higher expenses, mutual funds aren’t really the most efficient investment vehicle tax-wise. Unless you plan on utilizing tax-loss harvesting or investing in mutual funds through a 401k, IRA, or Roth IRA, the capital gains tax implications might take a sizable bite out of your profits.

Fixed Income 🏦

Fixed-income securities are some of the most conservative and safe investment vehicles at your disposal. This category includes bonds and treasury bills.

So, what’s the deal with this asset class? Well, these are debt instruments—they are issued by governments or corporations in order to raise capital. In return, the investor who purchases these instruments receives a certain amount of interest, usually twice per year, as well as full repayment at a predetermined date.

No matter if we’re talking about bonds or treasury bills, the same factors are the most important ones—the interest rate, maturity or timeframe, and amount borrowed.

How Bonds Work 🤲

Bonds are a low-risk asset that allows you to receive a small passive income from interest payments. If you’re interested in how bonds work, take a look at this guide—but we’ll go over the basics here.

There are four key characteristics that you should look at when purchasing bonds. The first is face value—the amount of money that the bond will be worth once it reaches maturity. For example, a bond with a face value of $500 entitles you to that amount of money at maturity.

The second factor is the coupon rate—the interest rate that you will be paid for holding the bond. It is calculated by using the face value of a bond—so, for example, if our $500 face value bond has a coupon rate of 12.5, you’d get $12.5 for each payment of interest.

A Basic Diagram of How A Bond Works
Bonds are debt, and as such, guarantee that the lender will be paid, provided that the lendee doesn’t go bankrupt.

Coupon rates let you know when those interest payments will happen—usually, this occurs twice a year. And finally, the maturity date lets you know when the issuer of the bond will pay you the face value, as we’ve mentioned.

But not all bonds are made equal—when you’re looking for a bond, pay attention to the issuer’s credit rating. Although these are low-risk securities, they are definitely not risk-free. And while we’re talking about drawbacks, keep in mind that after the initial Covid-19-related government spending, bonds aren’t doing too well—and they generally don’t perform well in high-inflation, low interest rate environments.

Treasury Bills, Notes, and Bonds 💴

The biggest difference between treasury bills and bonds is that treasury bills operate on a much shorter timeframe—one year at the most, while bonds usually have a maturity longer than one year.

As you might have guessed from the name, these securities are issued by the U.S. government. Treasury bills have maturity dates ranging from 4 weeks to a year, treasury bonds have maturity dates ranging from 2 years to 10 years, and treasury bonds have a maturity date of 30 years. All of these securities are regularly auctioned off by the U.S. Treasury in online auctions. 

Fixed-income securities issued by the Treasury have two main advantages—first, they have solid backing, meaning that the chance of default is close to zero—and second, the interest earned from these securities is exempt from local and state taxes.

While fixed-income securities, in general, don’t do well in periods of high inflation, Treasury Inflation-Protected Securities (TIPS) are indexed to inflation, and offer a great way to include low-risk assets in your portfolio should inflation occur—however, they generally have lower interest rates than other fixed-income investment vehicles.

Cash as an Asset 💵

Cash and cash equivalents form their own asset class. While cash doesn’t offer much in the way of returns, seeing as how the interest rates offered by savings accounts are paltry, it does offer plenty of utility in different ways.

For one, cash is the way you settle living expenses, and in times of recession, a rock-solid emergency fund is a must—but apart from that, having access to a decent sum of cash on hand allows you to make use of investment opportunities as soon as you spot them.

On the other hand, cash has a nasty habit of getting spent when it’s readily available—out of sight, out of mind definitely applies here. On top of that, cash will also suffer the effects of inflation—meaning that its real buying power will decrease year after year.

Sure, the inverse also holds true—in deflationary periods, cash becomes worth more than previously was, but to be perfectly fair, this is a very rare occurrence.

All of the above also applies to cash equivalents in the form of money market instruments, which include marketable securities, commercial papers, and certificates of deposit. All of these instruments are highly liquid and can be converted to cash at relatively short notice—usually 3 months.

Still, when all is said and done, holding large sums of cash is an absolute waste—you’ll only be letting inflation gnaw at your wealth that way. We recommend keeping a tidy sum close at hand for making use of new opportunities, as well as a 3 to 6-month emergency fund, but apart from that, cash just isn’t a good asset class for a vast majority of investors.

Forex Exchange Market Explained 💱

The foreign exchange market (commonly shortened to forex) deals with buying and selling national currencies. It is actually the largest financial market in the world, with a daily turnover of approximately $6.6 trillion, and it is open 24/5.

Forex traders seek to utilize the fluctuations in exchange rates to secure gains. The value of a currency can go up or down, depending on the present supply and demand. If a forex trader anticipates that a certain currency will go up in value, they will buy that currency using money held in a different one, wait for the price to rise, then revert the money to their previous currency—and the difference between the price at which they bought and sold is pure profit.

Currency Price Factors
The exchange rates of currencies depend on a plethora of macroeconomic and other factors, making the forex markets very lively trading environments.

That might seem a bit hard to grasp, and we admit, that is a paragraph dense with information. So, we’ll turn to our favorite method of all time—a hypothetical example.

Let’s say that you’re planning on visiting Switzerland. You’re packed, everything is set, Geneva awaits, and to cover the expense of food at the airport, you exchange 100 U.S. dollars for 92 Swiss Francs. 

However, in the meantime, your flight is canceled, and the value of the Franc increases. Now, a few days later, the 92 Francs you bought for $100 are worth $105. If you exchange the money again, you’ve made $5.

Obviously, this is an oversimplification. Forex trading is complex and comes with its own terminology. It also relies heavily on margin, so it comes with quite a lot of risk that many adrenaline-loving traders often don’t hedge sufficiently. If you’re new to forex, be sure to learn the fundamentals of forex trading before getting started.

Is Cryptocurrency an Asset? 🪙

Cryptocurrency is a hot-button topic—rarely anyone is indifferent to crypto nowadays. And it’s easy to see why—although this relatively new asset class has given us plenty of success stories and tall tales of wild returns, it is also very risky, volatile, and still in its infancy.

Still, even though the crypto market is a whole nother ball game with its own set of rules, and risky as it may be, you can’t afford to ignore it. Cryptocurrency has seen a rapid expansion in the past couple of years, and it is showing no signs of stopping down. In fact, with the widespread adoption of crypto, it’s not crazy to assume that the growth of the market will in fact accelerate.

We’re not going to zero in on specific cryptocurrencies here—that would take too much time and divert from the point of this guide. So let’s deal with the general attributes of this exciting new asset class.

Obviously, cryptocurrencies are very volatile, but that goes hand in hand with huge return potential. And although the volatility is significant, when you look at the long run, cryptocurrencies also experience growth in that regard—meaning that they might not be bad long-term investments.

Although we have much less historical data than with other asset classes, it seems like cryptocurrencies might offer another hedge against inflation—as the adoption of crypto accelerates, its ability to be used instead of inflated government-mandated currencies is all the more appealing.

Real Estate and Other Tangible Assets 🏡

Real estate and other tangible assets such as art, vehicles, collectibles, and other items of value form their own asset class. Although this might seem like lumping way too many different things into one category, they’re set apart from other investment classes by one key factor—they aren’t traded on exchanges.

Real estate is the most straightforward of these assets—depending on the state of the local housing market, it can either appreciate or depreciate in value, and if is rented out as commercial or residential property, it also serves as a source of passive income via rent.

Other tangible assets are a bit trickier—they can’t provide passive income, and appreciation isn’t guaranteed. Art and collectibles can easily appreciate in value—but this requires know-how when choosing what to buy, and the fees charged by auction houses can be pretty steep. Out of all the tangible assets, vehicles are the least appealing—they can only depreciate with time.

Real Estate Investment Trusts 🏘️

Now, obviously, real estate has one major drawback—it’s expensive. It takes a lot of money to buy a property, and saddling yourself with such a huge amount of debt, especially if you’re young, might not be the wisest choice.

So, does this mean that you’re practically locked out of the real estate market if you don’t have a lot of money at your disposal? No—you’re not. This is where real estate investment trusts or REITs come in.

A REIT is a company that buys and operates either commercial or residential real estate. They operate most similarly to mutual funds, but with a couple of key differences—the most major one being that REITs are required by law to pay out at least 90% of their taxable income to shareholders in the form of dividends.

On the flip side, REITs usually have above-average fees, are sensitive to rising interest rates, and the dividends that you’ll earn from them are taxed in the same way that regular income is. However, REITs are the best way to gain exposure to the real estate market without having to invest large sums of money.

Are Derivatives an ‘Asset’? 💶

Derivatives are a bit trickier than the rest of the asset classes. They are complex financial instruments—unlike most of the asset classes we’ve already covered, they also factor in time.

Derivatives include futures, options, swaps, and forwards. For the sake of convenience, we’ll cover options and futures in this guide—swaps and forwards are even more complex, and they are traded in over-the-counter (OTC) markets, so they require a guide of their own.

The value of a derivative is based on the value of some other underlying asset. In the case of options, which are the most popular type of derivative, you’re not actually buying an asset—instead, you’re buying the right to buy or sell that asset before a specified later date, and at a predetermined price.

Let’s use an example. If a company’s stock is currently trading at $15, but you have reason to believe that it will see a price increase, you can buy an option that gives you the right to buy the stock at $15 in two weeks’ time. This is referred to as a call option. The right to sell a stock at a later date is a put option.

In their simplest form, options are tools used for betting on assets (primarily stocks) without actually buying them, and thus, using less capital.

If the stock price does indeed rise, you’re in the money—you can buy the stock at a discount, sell it at the new, higher price, and walk away with the difference as profit.

It’s impossible to say what the average return with options is. These are complex financial instruments, so trading them requires quite a lot of knowledge and experience. Still, derivatives can net you great returns—and if you’re still too risk-averse or unsure, you can always make use of trading software or an options alert service to make the trading process simpler and more successful.

Commodities 💷

Commodities are goods or materials that play an important role in the supply chains of many more complex products or can be used as they are. One important factor that sets commodities apart from other resources is that they are fungible—in other words, they are standardized and can be exchanged.

So, what do commodities encompass? They are usually classified according to two criteria: first of all, commodities can be soft (like sugar, soybeans, wheat, and other agricultural products, including livestock) and hard (oil, natural gas, gold, copper, lead, aluminum, and rubber).

The other method by which commodities are classified divides them into four broad groups: agriculture, metal, livestock and meat, and energy.

Here’s where things get tricky. Apart from gold, which you can sensibly buy and store physically, you’re not really going to actually buy any of these commodities. Storing bushels of wheat or tons of copper simply isn’t doable in modern times—so, how are commodities traded then?

The answer is simple—either by investing in businesses that produce these commodities, usually via purchasing stocks and bonds or by derivatives—most commonly futures. A futures contract is a legal obligation to purchase a set amount of a commodity at a future date. Futures allow investors to speculate on the upcoming price movements of commodities without actually taking possession of them.

Commodities are radically different from other investment classes—their price movements are much more tightly related to supply, demand, and production. While they don’t require the detailed understanding of fundamental and technical analysis that trading other asset classes do, they’re a complex topic that requires plenty of time to master.

The Problems with Asset Classification 💲

Unfortunately, as is often the case in the world of finance, nothing is by-the-book and cut-and-dry 100% of the time. There are cases where the lines get a bit blurrier, and some asset classes overlap. So, that complicates things a bit—but just by how much?

Well, thankfully, the situation isn’t all that bad. Let’s take a common example—ETFs. While they are, at their core, an equity, and behave as such, they can contain fixed-income securities and currencies. So, how do you make sense of that mess?

At the end of the day, ETFs act more like equities than anything else. You know what they say—if it walks like a duck…

These are, of course, general rules—you’ll still need to pay attention to the specific circumstances regarding all of these “overlapping cases”. Therefore, if an ETF is bond-heavy, you can expect it to correlate more with bonds.

Another common area where the lines aren’t that clear is tangible assets. While gold and silver clearly fall into this category, they aren’t usually traded as such—rather, they are traded via derivatives such as futures or options. So, do they fall into the category of derivatives or commodities?

Well, once again, the proof is in the pudding—although both gold and silver and most commonly traded via derivatives, they don’t share the qualities and average performance of derivatives—so they’re rightfully classified as something separate.

Another key point to make is that not all assets in the same class are made equal. In fact, plenty of investment professionals treat domestic equities and foreign equities as separate asset classes, due to the large difference in how they perform—so keep this in mind as well.

How to Invest in Different Asset Classes 💭

So, as you might have heard, putting all your eggs in one basket is a rather risky and amateurish move. You’ll want to diversify your holdings—that way, if some of them fail to generate gains, the others are more likely to pick up the pace.

Sounds simple enough, right? Just don’t put all of your money in one single place, right? Wrong—there’s a lot more to proper diversification than just that. What you want is to construct a portfolio that makes use of asset classes that are negatively correlated. 

What does negatively correlated mean? In simple terms, when one of those asset classes goes down, the other one goes up. This is one of the keystones of Modern Portfolio theory, which has served as a basis for the investment strategies of large financial institutions worldwide for decades.

To give you the most obvious example, it’s a known fact that when the S&P 500 goes down, gold goes up. Because of this fact, gold can serve as a hedge in the case of falling equity prices. But it doesn’t stop there—various correlations exist, allowing for a multitude of options when choosing to diversify.

There is another important point to mention here—just as the principle of diversification is important across asset classes, it is also important within a single asset class. To put it plainly, you don’t want to have all of your stock investments tied to one stock, or all of your ETF investments tied to one fund.

The perils of such an approach are most apparent with stocks—even if you’re confident that a certain industry is going to experience growth, there’s no way to completely accurately tell which companies will end up being industry leaders. So, what do you do in that situation? It’s simple—diversify, spread your investment across multiple businesses, and reduce the risk that you’re exposing yourself to.

Conclusion 🏁

So there you have it—that’s the long and short as far as asset classes are concerned. Mastering the inner workings of each one will take a while, but a solid understanding of the basics of all the asset classes is essential if one is to invest successfully.

Congratulations for making it to the end—now that you have the basics figured out, you can continue on in the direction of the asset classes that interest you the most.

Asset Classes: FAQs

  • Which Asset Class is Considered the Most Liquid?

    Out of all the asset classes, cash is the most liquid by far. After that, cash equivalents, such as CDs, and highly traded stocks and bonds are the most liquid, followed by other types of asset classes. 

  • Which Asset Class is Considered the Least Liquid?

    The least liquid asset classes are land, real estate, private equity, and artworks.

  • What's the Cheapest Asset Class?

    The cheapest asset classes include small-cap equities, affordable ETFs, and commodities.

  • What's a Good Asset Mix?

    A common asset allocation is 60% in stocks and 40% in bonds. Although a slightly dated investment principle, it still offers a good balance of risk and returns.

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