Understanding Asset Classes for Your Investment Portfolio
Asset classes represent similar types of investments. In general, I categorize assets into five major classes:
- Equities (stocks)
- Fixed income (bonds)
- Cash & equivalents
- Alternative investments (real estate, commodities, art, etc.)
- You and your income generating potential
The first asset class represents an ownership share of a company and is often categorized as follows:
- Investment styles, such as growth vs. value or a blend of the two;
- Location (the U.S., foreign developed or foreign emerging);
- Company size or market capitalization (small-, mid- or large-cap).
Instead of investing in one company at a time, it is possible to purchase a portfolio of companies through investment funds known as mutual funds or exchange-traded funds (ETFs). The latter two differ in their method of purchase, pricing and the kind of fees/expenses charged. More recently, ETFs have increased in popularity due to their ability to be traded on open exchanges and their development of unique investment strategies.
Fixed Income (Bonds)
The second asset class, fixed income, represents a loan to a company or government in exchange for an agreed-upon set of payments. Unlike equity investors, fixed income investors do not have an ownership stake in companies but are creditors. Bond investors typically have a higher claim on assets than equity owners if there is a bankruptcy default. Fixed income securities are categorized by:
- Issuer (corporation, municipality called munis, or Federal Government called Treasuries)
- Location (U.S. or foreign)
- Maturity range (1 month to 30 years for U.S. Treasuries).
- Credit rating (typically categorized from AAA to junk and everywhere in between).
- Contract terms (discounted zero-coupon payments, convertible, callable, putable).
As with equities, it is possible to purchase a portfolio of fixed income securities using ETFs or mutual funds. In general, bond prices fall when interest rates go up and vice versa. Additionally, bonds become more valuable with an improved credit rating.
Cash & Equivalents
The third asset class, cash & equivalents, is the money stored in your checking and savings accounts, in your wallet, purse and under your pillow. It is a crucial part of your portfolio and represents your liquidity to cover expenses. The proper management of liquidity enables continued growth of the other asset classes and helps to avoid selloffs of securities during market downturns. Unfortunately, a lot of people fail to recognize the importance of this asset class as a liquidity management tool.
The fourth asset class includes alternative investments, which is somewhat a mishmash of investments that lie outside of the first three asset classes. These include:
- Commodities (precious metals, agriculture, livestock, and energy)
- Real estate (commercial and residential, foreign and domestic)
- Collectables (fine art, jewelry, wine, cars, and other items deemed valuable)
- Private investments (direct company investments, private equity, venture capital, private debt placement, hedge funds and fund of funds, etc.).
Many of these alternative investments can be purchased directly or through pooled funds. Private equity tends to encompass a broad classification of investments in private businesses. Venture capital is a subcategory of private equity focused on early-stage investments in startup companies. Hedge funds tend to focus on investing in a particular strategy (macro, event-driven, arbitrage, etc.) that is an area of specialty for the portfolio manager. Fund of funds is a concept where a fund manager will invest in a portfolio of funds, rather than investing in stocks, bonds or other securities. The alternative asset class can get quite complicated. In general, opportunities in the alternative asset class require accredited investors who are wealthy enough to take risks associated with these investment vehicles. However, many of these alternative investments have found their way to public exchanges through securitization, fund listings and mutual funds trying to replicate similar strategies. Success is mixed at best, and access to the “Masters of the Universe” in alternative investments favors those who can supply large sums of capital and who can afford the hefty fees.
The fifth primary asset class, which often gets overlooked, is you. However, if one defines an asset as an income producing entity, then you are an asset if you can make a profit. I’ll leave it to you to determine what to call someone that only makes expenses. You are probably the most important asset as the majority of your income generation will come from your profession and the skills you acquire during your career. Hence, a lot of your time and expense should focus on increasing your asset value.
If you Invest in yourself, you could ultimately generate more income, which gives you greater liquidity and expands your investment options for the long term. Hence, don’t overlook investing in yourself first and always ask whether making a self-investment will give you a higher return than investing in other asset classes.
In our next blog, we’ll analyze the rationale for investing in those other asset classes, assess their overall performance and come up with a roadmap for designing a proper investment portfolio. Until next time.