Portfolios of experienced investors typically consist of stocks, bonds, cash, and real estate (plus often an insurance program). A small part of the funds is also stored on bank deposits and sometimes in precious metals and goods. These instruments are called asset classes.
What Are Asset Classes?
An asset class is a broad group of securities or investments with similar financial characteristics. Combining different asset classes in one portfolio is called diversification. It helps manage the amount of risk that you take when building your portfolio and makes it balanced. Each asset class is expected to reflect different characteristics of risk and return on investment and operate differently in different markets.
Each asset class has its own degree of risk and profit potential. Cash has the lowest risk whereas bonds have the highest risk. If you need a low-risk portfolio, you should strive to retain a significant proportion of your investments, such as cash and fixed-interest securities. A higher risk portfolio will have a relatively high share in stocks.
The value of this asset class tends to grow significantly and drop in a short period of time. However, the longer you invest in shares, the higher the probability of making a profit in the long term. Therefore, it is necessary to invest as early as possible, which will allow you to form an aggressive profitable portfolio.
There is a theory that the optimal number of shares in a portfolio is described as one hundred minus your age. Accordingly, if you start investing when you are 20, you can afford 80% of the shares, because you will be able to easily endure the ups and downs of the market.
Unlike stocks, bonds are known as fixed-income asset classes. When you buy a bond, you can receive regular interest payments on it before the expiration date. If a share implies ownership of a part of a company and its business, then a bond is a debt instrument, i.e. lending money to the state or corporation. In the case of a default, bond holders have a priority for the return of funds compared to the share owners.
The issuer of the bond is obliged to pay you its face value - the amount of the invested funds - at the maturity (expiration) date of the bond. Highly profitable bonds can be a very risky financial instrument. Conservative investors should choose reliable government bonds of developed countries with regular financing and low volatility but with lower profit.
You can invest in property by using the REIT (Real Estate Investment Trust) funds. In fact, these are companies that build, acquire, and rent real estate. The first realty funds were established in the USA in 1960, and today the turnover of the largest funds is comparable with the turnover of the largest stock market shares.
The longer you own the real estate funds, the more the income received from them corresponds to the income of the direct property owner. At the same time, correlation with the US stock market drops over time, which favorably affects the profitability of the total portfolio. So, for a portfolio investor, this asset class provides good dividends, low correlation with the stock market, and profit fluctuations at the stock market level.
Commodity assets (oil, metals, sugar, etc.) grow over long periods of time by the value of inflation while showing a large range of fluctuations. At the same time, they cannot create additional cash flow in the form of dividends and thus are both a highly risky and low-profitability option.
Gold is a special case of a commodity asset - however, it also has a negative correlation with the market. This makes it a candidate for allocating a small (5-10%) share of the portfolio, especially during a crisis period. Therefore, gold in an investment portfolio often behaves against the market trends, smoothing the profitability. Many investors believe that this asset class has long-term perspectives.