What are Asset Classes? 4 Different Types of Asset Classes You Should Know
Investments are grouped into asset classes. The main aim to classify asset classes is to help investors better understand their portfolio. This in turn helps investors to diversify their portfolio.
What is an Asset Class?
An asset class is a collection of investments based on shared characteristics, behaviours, and regulations. These are influenced by similar rules and regulations and behave almost in the same way in the market.
However, it’s crucial for investors to understand different types of asset classes to make an informed decision while investing..
Understanding Asset Classes in Detail
The table below represents the risk and returns offered by some asset classes.
| Asset class | Risk of loss | Return / Growth potential |
| Cash and cash equivalents | Very low | Very low |
| Equities | High | High |
| Fixed income | Low | Low |
| Alternative assets | Varies | Varies |
Equities hold the highest growth potential among other classes. However, if investors want a high level of returns, they must bear high risks and volatility. Diversifying portfolios is a great way to reduce the risk and protect yourself from volatility.
You can do so by diversifying your investment into different asset classes in a balanced combination. Point to note: stock market factors don’t directly impact cash, fixed income, and alternative asset classes.
For instance, when the stock market takes a dip, it would neither impact your cash balance nor the interest you receive on your fixed-income securities. This is why diversifying your investments is beneficial since it spreads risk and increases the scope of return.
Also Read: Understanding Asset Allocation and Different Asset Classes
Types of Asset Classes
Here are the different types of asset classes:
1. Cash and cash equivalents
These rank lowest on risk profiles. Furthermore, since cash and cash equivalents are physical assets, they negatively correlate to appreciation and depreciation.
Cash equivalents are investments that you can easily liquidate. Though you can always save more cash, you wouldn’t receive higher returns from interest. However, they are a safer asset class compared to their peers.
2. Equity
If equities or the stock market excites you most, you must begin by exploring how it works and understand its exposure to risk. The value of equities heavily depends on the companies’ performance, the company’s growth outlook, demand and supply of the shares, among other factors.
Consult a financial expert before investing in the stock market.
3. Fixed income
This includes bonds, debentures, T-bills, loans, or securities that are split into units to be sold to investors. Investors receive interest payments in exchange for the principal they invest until the security matures. Upon maturity, the principal investment amount is returned back to the investor.
Although fixed-income securities do not increase in value over time, they provide steady, predictable income. Moreover, fixed-income investments are also known for their low risk and moderate returns.
4. Alternative asset classes
Alternative asset classes include commodities like silver, gold, crude oil, real estate, venture capital, foreign currency, private equity, etc. These are unconventional investments that usually deviate from other types of asset classes.
Diversification within Asset Classes
Diversification involves holding multiple equities and fixed-income securities to reduce the risk of losses. You should keep the following points in mind while diversifying investment:
- Diversification into stocks influenced by similar factors does not help mitigate risk since it carries the same risk. However, you can spread out your risk exposure by investing across companies of different sizes and sectors.
- It may happen that you diversify too much across asset classes – to the point where each new security reduces your growth more than it limits your risk. Holding too many stocks or investing in funds with overlapping portfolios can lead to over-diversification. It is known as over-diversification and must be avoided to maximise returns.
Also Read: What Is Non-Performing Asset (NPA) In Banking?
How does Asset Class Diversification Work?
Below are some examples of how asset class diversification works:
- You can protect your portfolio from unsystematic risks by investing in a bunch of individual stocks. You can also invest in mutual funds or index funds that invest in an array of stocks and/or bonds.
- Companies in the same sector can perform similarly due to various external factors. On the other hand, sectors too can underperform due to changing consumer behaviour, regulator factors, supply chain disruptions, and more. Diversification by investing in various sectors can help you mitigate this risk.
- Systematic risks occur when the entire stock market crashes due to macroeconomic trends, global pandemics, recessions, etc. Its rippling impact could be felt across industries around the world. Systematic risk is both unpredictable and inevitable. You can reduce the risk of exposure but not completely eliminate it. This is possible if you diversify into non-equity assets.
Final word
You must thoroughly understand an asset class before diversifying investments. Furthermore, you can apply the ins and outs of diversification, unsystematic risk, and systematic risk to your investment portfolio for more returns and reduced risks.
FAQs on Asset Classes
Ans. An asset class comprises a group of securities sharing the same characteristics and are governed by similar laws and regulations.
Ans. Asset classes include equities (stocks), cash and cash equivalents, fixed-income and debt (bonds), and alternative assets.
Ans. Cryptocurrency shares the similar patterns and characteristics as other asset classes and can be considered as an alternative asset class.
Disclaimer
This article is solely for educational purposes. Navi doesn't take any responsibility for the information or claims made in the blog.
