What Are Asset Classes?
Asset classes refer to a group of securities with comparable features and responses to market variations. It aids the investors in deciding the proper investment strategies and receiving maximum profits with minimal risk prospects. The asset classes types include fixed income, cash & cash equivalents, equity, and real estate.
Each asset class is unique regarding the related risk, taxation, ownership, exchangeability, revenue, rules, and market instability. Moreover, the asset classes list is organized according to each asset’s nature, response to market volatility, returns, and target.
Table of contents
- Asset classes depict a collection of different financial instruments with identical traits and market behavior.
- They are arranged as per the reaction to each asset’s market fluctuations, nature, and financial goals.
- There are five crucial asset categories: derivatives, fixed income, real estate, cash & cash equivalents, and equity. Also, the alternative categories include bitcoins and hedge funds.
- Diversification of asset types helps reduce the overall risk and losses and obtaining the expected portfolio returns.
Understanding Asset Classes
Asset classes definition implies an assortment of investment vehicles with similar characteristics and behavior in the marketplace. Besides the types mentioned above, the asset classes list also covers hedge funds, collectibles, and Bitcoin. These are called alternative investments due to being more illiquid and riskier.
Investors must have a complete knowledge of different asset categories. It helps them diversify risks and increase awaited profits. Accordingly, they can choose the apt asset allocation strategy to maximize gains.
Here lie the top five asset classes types:
Equity denotes the amount belonging to the shareholders or owner after the discharge of dues and assets, in case of liquidationLiquidationLiquidation is the process of winding up a business or a segment of the business by selling off its assets. The amount realized by this is used to pay off the creditors and all other liabilities of the business in a specific order.. Precisely put, it depicts the ownership shares issuedIssue Equity SharesShares Issued refers to the number of shares distributed by a company to its shareholders, who range from the general public and insiders to institutional investors. They are recorded as owner's equity on the Company's balance sheet. by the firm in lieu of the paid-up capitalPaid-up CapitalPaid in Capital is the capital amount that a Company receives from investors in exchange for the stock sold in the primary market, including common or preferred stock. This considers the sale of stock that an issuer directly sells to the investor & not the sale of stock on the secondary market between investors. . Not bounded by the dividend paymentsDividend PaymentsDividends refer to the portion of business earnings paid to the shareholders as gratitude for investing in the company’s equity., equity is the only funding option in the event of credit riskCredit Risk IssuesCredit risk is the probability of a loss owing to the borrower's failure to repay the loan or meet debt obligations. It refers to the possibility that the lender may not receive the debt's principal and an interest component, resulting in interrupted cash flow and increased cost of collection. .
Also, it has sub-divisions such as large-cap/mid-cap/small-cap stocksSmall-cap StocksSmall cap stocks are offered by relatively small companies that are publicly listed. A small cap company has a low market capitalization ranging between $300 million to $2 billion. Small cap investors have a high-risk, high-reward approach., thematic funds, value funds, sectoral funds, etc.
Here goes the accounting equationAccounting EquationAccounting Equation is the primary accounting principle stating that a business's total assets are equivalent to the sum of its liabilities & owner’s capital. This is also known as the Balance Sheet Equation & it forms the basis of the double-entry accounting system. :
Equity = Assets – Liabilities
2. Cash and Cash Equivalents
It denotes the available money and most liquid (swiftly cash convertible) current assets in an enterprise. Cash and cash equivalentsCash And Cash EquivalentsCash and Cash Equivalents are assets that are short-term and highly liquid investments that can be readily converted into cash and have a low risk of price fluctuation. Cash and paper money, US Treasury bills, undeposited receipts, and Money Market funds are its examples. They are normally found as a line item on the top of the balance sheet asset. are short-term investments for operational expensesOperational Expenses.Operating expense (OPEX) is the cost incurred in the normal course of business and does not include expenses directly related to product manufacturing or service delivery. Therefore, they are readily available in the income statement and help to determine the net profit. and have high credit quality. Furthermore, it includes commercial papersCommercial PaperCommercial Paper is a money market instrument that is used to obtain short-term funding and is often issued by investment-grade banks and corporations in the form of a promissory note., money market instruments, US Treasury bills, etc.
3. Fixed Income
Fixed income offers systematic fixed-rate interest earnings to the investors till the maturity date. Therefore, it is among the earliest and most favored investment types due to being cheaper than equity financingEquity FinancingEquity financing is the process of the sale of an ownership interest to various investors to raise funds for business objectives. The money raised from the market does not have to be repaid, unlike debt financing which has a definite repayment schedule.. Examples include corporate debt securities, government (US Treasury billsTreasury BillTreasury Bills (T-Bills) are investment vehicles that allow investors to lend money to the government.), corporate bondsCorporate BondCorporate Bonds are fixed-income securities issued by companies that promise periodic fixed payments. These fixed payments are broken down into two parts: the coupon and the notional or face value., etc. The following asset class example shows how corporate bonds work:
An investor buys a corporate bond worth $1,000 with a maturity period of 5 years. The issuer promises to pay a 5% yearly coupon rateCoupon RateThe coupon rate is the ROI (rate of interest) paid on the bond's face value by the bond's issuers. It determines the repayment amount made by GIS (guaranteed income security). Coupon Rate = Annualized Interest Payment / Par Value of Bond * 100% until the bond matures. Now, the payment structure will be as follows:
4. Real Estate
Real estate involves tangible assets commonly purchased for either residential/commercial usage or future investment. It entails plots, condos, mansions, retail centers, industrial estates, etc. Furthermore, the asset class provides safety against inflation and guarantees huge financial gains.
The derivatives are financial contractsDerivative Is A ContractDerivative Contracts are formal contracts entered into between two parties, one Buyer and the other Seller, who act as Counterparties for each other, and involve either a physical transaction of an underlying asset in the future or a financial payment by one party to the other based on specific future events of the underlying asset. In other words, the value of a Derivative Contract is derived from the underlying asset on which the Contract is based. between at least two parties whose value relies upon the underlying asset or a group of assets. The financial agreement sets an expiration date till when the investors can (obligation for forwards/futures) trade the asset at a set rate. They are traded to hedgeHedgeHedge refers to an investment strategy that protects traders against potential losses due to unforeseen price fluctuations in an asset against risks through long or short positionsShort PositionA short position is a practice where the investors sell stocks that they don't own at the time of selling; the investors do so by borrowing the shares from some other investors to promise that the former will return the stocks to the latter on a later date..
The contract pricing settled at the time of agreement is called the strike priceStrike PriceExercise price or strike price refers to the price at which the underlying stock is purchased or sold by the persons trading in the options of calls & puts available in the derivative trading. Thus, the exercise price is a term used in the derivative market.. It has four types, i.e., Forwards, Futures, Options, and Swaps.
Commodities are doing inexplicably well during the sudden inflationary bouts and may be chosen for the retirement portfolio. It is the 3rd best performing asset class in 2021, followed by Bitcoin and West Texas Intermediate (WTI) Oil.
Moreover, the 2021 S&P Goldman Sachs Commodity Index (GSCI) gained 37.1%, surpassing the S&P 500 and other equity indices. They perform well during inflation and are a relevant category during the portfolio’s asset allocation.
However, some experts state that profits from trading commodities are gained at the expense of other traders. Hence, there has been no final opinion on the matter.
The alternative asset classes have witnessed a 38% surge in commitments obtained from domestic investors. The increment is due to the clients’ desire to participate in private markets via private equity and personal debt.
Moreover, lower returns on fixed income products and expanded equity valuations are behind such allocation. The robust secondary equity market through 2020-2021 is the significant motivation for the enhanced alternative fund investment.
Diversification Of Asset Classes
Asset categories diversification is essential for development-oriented companies with future expansion plans. No two markets operate likewise at the same time. Therefore, diverseness prevents a corporation’s poor market performance because of a lag in one asset class.
Diversification intends to reduce the general risks and losses and boosts the preferred portfolio returns. Mutual fund specialists make a list of distinct asset classes for investment to avert concentration risk and ensure portfolio diversification.
Investors must examine their risk tolerance, investment horizon, and financial objectives before the allotment of funds. For example, risk-averse investors must select fixed-income securities, while risk-tolerant investors must pick Equity.
Furthermore, the capital asset pricing model (CAPM)Capital Asset Pricing Model (CAPM)The Capital Asset Pricing Model (CAPM) defines the expected return from a portfolio of various securities with varying degrees of risk. It also considers the volatility of a particular security in relation to the market. is applicable if the rates of common stocksCommon StockCommon stocks are the number of shares of a company and are found in the balance sheet. It is calculated by subtracting retained earnings from total equity., preferred sharesPreferred StockA preferred share is a share that enjoys priority in receiving dividends compared to common stock. The dividend rate can be fixed or floating depending upon the terms of the issue. Also, preferred stockholders generally do not enjoy voting rights. However, their claims are discharged before the shares of common stockholders at the time of liquidation., or debts rise.
Tangible assets such as commodities and real estate perform well during inflation and increased interest rates. Both of them have always been viewed as inflation hedges. It assists the investors to thrive during an inflationary environment.
Alternative assets are the most unexpected and illiquid asset classes for investment. These assets do not come under the usually accessible traditional classes. Instead, they are complicated and heavily regulated.
It includes real estate, commodities, insurance products, venture capital, and foreign currency.
Commodities, real estate, and cryptocurrencies like bitcoin are currently the most undervalued asset classes. These sectors have been performing amazingly well over the years but didn’t get the much-needed recognition. Nonetheless, the marketplace has shifted its focus towards them, resulting in enhanced investment.
This has been a guide to what are Asset Classes and its definition. Here we discuss the list of top 5 types of asset classes along with examples and explanations. You can learn more about Asset Management from the following articles –