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What are assets in the context of investing? What are the three main types of asset classes?
Asset classes are the building blocks of investing. Asset classes are simply types of investments (like stocks or bonds), and each asset class has varied assets within it. For example, “stocks” is an asset class composed of all kinds of different stocks: large companies, small companies, international companies, and so on.
In this article, you’ll learn about the three main types of asset classes and how to allocate and diversify your investments between them based on your age and risk tolerance.
Before you can start investing, you’ll need to understand the different types of asset classes that will make up your investment portfolio: stocks, bonds, and cash. Let’s look at each asset class in more detail, starting with stocks.
When you think of investing, you probably think of stocks first. Stocks are shares of ownership in a particular company. Stocks are one of the most unpredictable investments because their value is determined by the shareholders. For example, if a company seems to be doing really well, more and more people will want to buy stock in that company, which drives up the price of each individual share. But if something happens to shake people’s faith in that company (like a merger or a supply shortage), shareholders will start selling off their shares and cause the stock price to drop.
There are many different types of stocks. You’ll want to invest in several of these different types in order to create a healthy, diverse portfolio. Here are the most common types of stocks:
- Large-Cap. These are the big company stocks that have a market capitalization (the amount invested in that company by its current shareholders) over $10 billion.
- Mid-Cap. These companies have a market capitalization of $1 billion to $5 billion.
- Small-Cap. These companies have a market capitalization under $1 billion.
- International. These are stocks from companies in other countries.
- Growth. These are stocks that experts expect to grow in value, potentially outpacing the growth of the market as a whole.
- Value. These are stocks that are relatively low priced compared to their actual value.
Bonds are a different type of asset class. They’re a much more stable investment than stocks because the value of a bond doesn’t fluctuate based on the whims of the market. When you buy a bond, you’re essentially giving a small loan to the bond issuer (which can be the federal government, local governments, or a corporation) with a predetermined payback period. For example, say you buy a $100 bond with a 20 year term. If you hold onto that bond for the full 20 years (instead of selling it prematurely), you’ll get your $100 back, plus 20 years worth of interest.
Bonds provide a buffer against market volatility, which means that if some of your investments are in bonds rather than stocks, you won’t lose your entire investment if the market crashes. If you’re younger (in your twenties), you can afford to have a portfolio made up entirely of stocks, because even if you lose money, you’ll have enough time to earn it back before you really need it. If you’re in your thirties, you’ll want to start adding bonds into the mix since you have less time before retirement to bounce back if the market dips. If you’re in your forties or fifties, you’ll want the majority of your money to be in stable bonds—that way, you don’t risk losing your entire retirement income.
There are several types of bonds available, such as:
- Government. These are bonds issued by the federal government and are generally considered one of the safest possible investments. The tradeoff for that safety is a comparatively lower rate of return than stocks.
- Corporate. These bonds are issued by corporations. They’re a relatively safe investment (as long as the corporation stays in business).
- Short-term. These bonds mature in three years or less and provide relatively small returns.
- Long-term. These bonds take at least 10 years to mature, but provide higher yields than short-term bonds.
- Municipal. These are bonds issued by local governments.
- Treasury inflation-protected securities (TIPS). These are one of the safest investments because your investment won’t lose any value due to inflation.
In the past, financial experts recommended keeping part of your portfolio in cash, but as long as you’re funding your savings accounts, you don’t need to worry about this. In the context of investing, “cash” doesn’t refer to paper money—it’s any money that isn’t actively invested and is just sitting in a money market account, slowly earning interest. This type of cash is specifically part of your investment portfolio (so it doesn’t refer to the money in your savings account).
The benefit of having part of your portfolio in cash is that it remains completely liquid, which means you can withdraw it at any time, for any reason, without penalty. Traditionally, people kept part of their portfolio in cash in case of emergencies. However, that money will lose value over time due to inflation as long as it continues to sit there uninvested—which is why you shouldn’t set aside part of your portfolio for liquid cash.
Asset Allocation and Diversification
Now that we understand the building blocks of investing, let’s learn how to combine them into a healthy investment portfolio using asset allocation, which is the division of assets (like stocks and bonds) in your portfolio. Managing your asset allocation is the best way to control the amount of risk in your portfolio because you control how much of your money is invested in higher-risk options (like stocks) versus safer investments like bonds. In other words, the way you distribute your investments is more important than the specific stocks, bonds, or funds you choose to invest in.
Your asset allocation should reflect your risk tolerance. In your twenties and thirties, you can afford to take bigger risks with your money because you have plenty of time to recover from any losses before you retire. However, as you get older, your risk tolerance will decrease (because if you take a big loss in the stock market at age 59, you won’t necessarily have the time to recoup your investment before retirement). Your asset allocation should change to reflect those changes in your risk tolerance.
- For example, at age 35, you can afford to invest 90% of your money in stocks (a higher-risk option) and 10% in bonds (a low-risk option). By age 65, that allocation should change so that nearly half of your total portfolio is invested in bonds. At that point, you’ll be less concerned about growing your money and more concerned about protecting the money you’ve made from investing.
These numbers are just guidelines, not hard and fast rules, so you can adjust them based on your personal risk tolerance (so, if you’re young and want to be extra aggressive, you could invest 100% of your portfolio in stocks). Your financial situation also influences your asset allocation. If your net worth is in the millions, your investment portfolio should be almost entirely composed of bonds. You don’t need to aggressively grow your returns, so you have no reason to take unnecessary risks with your money.
There are two main investment strategies to choose from, and how you invest will ultimately depend on your financial needs as well as your risk tolerance.
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