What Are Asset Classes In Investments?

Article Summary

• Asset classes are investments that exhibit similar characteristics and respond similarly to market, economic, and other developments, besides having similar risk levels.

• While every asset class has the potential to create future income, due to their unique risks they have similar characteristics in terms of potential returns.

• Most common asset classes are cash, debt, equities, real estate, and commodities.

• It is essential for investors to understand asset classes to get an idea of how different asset classes move in relation to each other.

• Ideally, a diversified portfolio investing in different asset classes provides a balance between risk and reward.

Here is a fictional story of two friends Ramesh and Suresh who individually invest Rs 10,000 across different investments. Ramesh’s annual portfolio returns are 10% in three years. Suresh has a bumpier ride with 15% portfolio return in the first year, a fall of 20% in the second and 25% rise in the third year. Despite both receiving an average annual growth rate of 10% in their portfolios, after three years, Ramesh’s money has grown to Rs 13,310 while Suresh’s money has lumbered to Rs 10,789, or almost 19% less. So, what explains the difference? The answer: Compound Annual Growth Rate (CAGR).

While it was 10% for Tarak, it was only 2.56% for Jetha. The moral of the story: the more consistent the growth of an investment mix, the greater the savings. This lesson is important when investing for major financial goals such as children’s higher education and retirement.

Understanding asset classes for financial future Investments with the potential for high returns, like equities, also experience turbulence from time to time. The good news is that an investor can make such investments and aim for risk-reward balance in the portfolio. The key lies in understanding what are asset classes or investment asset classes, the types of asset classes, and applying the concept of asset classes to ensure the right mix of investments across asset classes, i.e., asset allocation.

What Are Asset Classes?

These are financial instruments that generally exhibit similar characteristics and respond similarly to market, economic and other developments. They have generally similar risk levels i.e., volatility of returns and impact on principal amount, besides a typical time horizon for best results. While every asset class has the potential to create future income, due to each class’s unique risks, it will have similar characteristics for potential returns. Also, each class typically has the same tax treatment.

Thus, investments in every asset class can play a distinct role in a portfolio. By understanding asset class types, investors can arrive at the right mix of investments across classes. 

Types of Asset Classes

After knowing the answer to the question “What are asset classes?”, it is time for a brief overview of different asset classes and broad understanding of every type of asset class.

Cash or cash equivalent This includes holding currency and near currency such as money in digital wallets. This asset has no scope for future growth and provides no protection from inflation. These investments help meet immediate needs and emergency expenses.

Debt They include investments in debt securities such as government and corporate bonds, certificates of deposits, bank and post office fixed deposits (FDs). These investments have lower risk compared to equities and experience lower volatility over comparatively shorter periods.

In the long term, the growth of debt investments faces inflation risk, risks from movements in interest rates, the risk of repayment, or credit risk by issuers of debt securities. Finally, there is reinvestment risk or the risk of not finding equal or more rewarding investments on maturity.

Returns from debt investments in the form of interest, dividends, coupon payments and capital gains are taxed at the applicable income tax rates. Such investments are appropriate for imminent and short term needs expected in 12-18 months to 4 years.

Equities This asset class typically involves investment in the equity shares of companies. In the long term i.e., 8-10 years, or more, investments in the equity asset class typically aim to provide returns higher than those in other asset classes. Of course, they experience periods of high volatility in the short term and are appropriate for long-term needs like retirement or a child’s higher education, which also require substantial savings.

Risk and volatility in equities can arise from domestic developments like changing business conditions, new information and analyses in areas like economic growth, inflation, and industrial growth. Announcements of monetary policy, especially interest rates, and government tax and other policies can also affect risk levels.

International developments such as those in major global economies like US and China besides global commodity prices can be a source of risk and volatility. Finally, company-related developments such as new information related to sales, profitability, and cash flows besides existing and new products and management quality, can also be a source of risk for equities.

Real estate This involves investments in commercial and residential real estate. Besides buying and selling, renting out real estate is also part of the investment process. 

Real estate investments get impacted by factors such as business cycles, market price movements, and property-specific factors like issues in the locality or tenant. Over the long term i.e., 5-10 years, real estate asset class may provide returns higher than inflation and can be useful for long-term goals like retirement. However, being a big-ticket investment, real estate is not accessible to small investors. The other challenge is liquidity i.e., quickly selling them like equities and debt.  

Commodities Investments in this asset class involve investing in precious metals like gold and silver, besides agricultural and energy commodities.

Typically, the returns from commodities are mostly delinked from those in equities and debt. This makes it an invaluable counterweight to them during asset allocation and helps in balancing the portfolio. Further, returns from gold investments have been found to act as a hedge against inflation.

While commodity investments, especially in gold, experience lower volatility than equities, they may have lower potential returns than equities. Returns from gold can also be muted during certain extended periods. Investments in physical gold also face issues related to purity, storage, and erosion of value at the time of exit. 

It is worth pointing out that investors can invest in these individual asset classes directly after understanding the type of asset classes and how to combine the investments. They can also do the same through mutual funds with the help of a financial advisor.

Why Do We Need Understanding of Asset Classes? 

Understanding asset classes not only develops our understanding of investment asset classes but also informs us which asset classes to invest in and in what proportion.

Benefit of diversification With the right asset allocation, adverse development in one asset class gets counterbalanced by growth in others. Typically, low, or negative correlation may exist among different asset classes. This prevents any disruptions in the overall growth of the portfolios for financial goals. 

Ensure appropriate asset allocation Depending on factors like time to financial goals and amount required, desired risk levels and tax treatment, one can opt for the right mix of the investment asset class.

Why You Need to Review Asset Allocation

To minimise the impact of adverse market movements in asset class types, you need to periodically review your asset allocation. Periodic reviews help you keep the mix of investment asset classes aligned with your risk profile. This typically involves rejigging investments, and reducing exposure in asset classes with enhanced risks. For instance, equity investments during booming markets. Periodic reviews also help investors exploit short-term investment opportunities. 

To conclude, asset classes in investments are the building blocks of a successful investment approach that can help achieve your financial goals.

FAQs

Why is it important for investors to understand inter-relationships among asset classes?

Different asset classes move in relation to each other. Some developments make asset classes move in the same direction. For instance, cuts in interest rates can help both equities and debt. In other cases, they can move in reverse directions. For instance, unfavourable news for equities, can help a commodity like gold. Mix of investments should ideally be from different asset classes that move in reverse directions. This can cushion the investor from adverse developments in any asset class.

Of course, it is important to note that inter-relationships may change over time. The impact of extreme and unprecedented events may be difficult to comprehend while the impact of some others difficult to fathom.

What should investors know about inter-relationships between different asset classes?

Investors need to understand how the inter-relationships have played out, and possibly changed over time due to macroeconomic factors, market cycles, and investment strategies.

Investors also need to know about the trends in the recent past and whether there have been deviations due to factors like technology, new investment strategies and other global trends. This needs to be supplemented with the understanding of likely future trends due to the play and interplay of various factors.

For this process, investors would do well to seek the help of qualified financial advisors.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.